The right to sell is referred to as a “put” option.
The farmer would buy the put option to protect against the possibility of the milk price falling below a strike price agreed to in the contract, but would retain the right to benefit from any increase in the milk price.
The option contract has an expiry date and if a farmer doesn’t want to sell the option at the strike price because the milk price has gone up he or she will let the contract expire and waive their right to sell on the futures market.
The price paid for the put option is similar to a premium in an insurance policy in that it is a true cost and not returned to the farmer. It must be deducted from the price the farmer receives on the physical market, if they let the contract expire, or the gain made in the futures market if they exercise the put option.
Example
In July 2016 the milk price futures contract for 2016-17 is trading at $6.50/kg MS.
Put options are available for the same season at a strike price of $6.50 for a premium of 60c/kg MS so a farmer buys put options.
Scenario one. Milk price rises
The physical milk price rises to $7.50/kg MS for the 2016-17 season so the farmer allows the put options to expire worthless.
The farmer receives $7.50/kg MS for his or her milk but has paid 60c/kg MS for the put options which they don’t get back.
The milk price they effectively receive is therefore $6.90/kg MS.
Scenario two. Milk price falls
The physical milk price falls to $5/kg MS which means the put option is “in the money”.
It can be exercised or sold before settlement or will automatically be exercised at expiration of the contract.
If the farmer exercises the contract he or she will have a futures contract which settles at $5/kg MS, creating a gain of $1.50/kg MS.
Once the premium of 60c/kg MS is deducted the price they effectively receive for their milk is $5.90/kg MS.
