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A2B-Lancastef Farming, Saturday, July 3, 1999
Dairy Options Pilot Program Design Offers
Farmers Opportunity To Set Floor Price
(ContlniMd from Pag* Al)
and the government program is
designed to help independent pro
ducers remain that way.
The DOPP program is not
designed to guarantee producers a
liveable income, but instead to
teach a corps of farmers how to use
the commodity trading marketp
lace to protect against losses.
The entire DOPP first meeting
series was presented by a team rep
resenting the USDA RMA, the
commodities trading industry, and
the farming industry.
At the Lancaster Farm and
Home Center meeting, the prog
ram was structured so that the
morning session consisted of an
explanation and overview of the
DOPP program by USDA
representatives.
The afternoon session began
with a dairy farmer who already
has been involved with trading
contracts with the help of the
USDA.
David Holzhauer of Meadow
Spring Farm, an area dairy farmer,
was selected in October 1997 to
serve as a regional participant in a
pre-program project. It was
described as a mini-DOPP.
The prc-DOPP program was
done in order to help establish peer
experience, according to David
Wiggins, regional service rep
resentative and an insurance man
agement specialist with the USDA
RMA.
Holzhauer’s participation in the
mini-DOPP was predicated on his
agreeing to serve as a member of
the team presenting the initial edu
cational meetings in the full-
DOPP.
Also on the afternoon slate of
speakers was Jim Grahm, in
charge of marketing for the Chica
go Mercantile Exchange.
He explained the program bas
ics and his outlook for dairy trad
ing. Also, commodities trading
industry representatives explained
their system of contracts and
trading.
A panel of brokers, who
explained their services,
responded to farmers' questions to
end the day's educational session.
It was explained by USDA that
for participating farmers, the
DOPP is a one-time, six- to eight
month limited program that essen-
MARTIN’S TIRE & ALIGNMENT
tially provides cost-sharing funds
to use “put" options available
through the New York Coffee,
Sugar and Cocoa Exchange and
the Chicago Mercantile Exchange.
Both trading houses have
offered dairy futures contracts and
options contracts for several years
with some success.
The DOPP program focuses on
the use of “put" options; a trading
contract that can be used by a far
mer to lock-in a bottom price on
certain weight of milk (100,000
pounds per contract at the CME),
while not limiting his ability to
receive higher market prices on the
actual sale of his milk.
It’s promoted as a form of insur
ance against severe drops in mark
et price.
The way it works is that a dairy
fanner, who knows that his month
ly production (and thus his sale of
milk) can be expected to be
100,000 pounds of milk (more or
less), continues to sell his milk just
as usual.
If he sells througha cooperative,
for example, he continues to do
that and receive his monthly milk
check.
However, since the dairy farmer
doesn't know how much he is
going to get paid for that milk until
after it is used, he is at high risk of
losing money.
Lots of it
The put option doesn’t involve
the sale of milk.
The put option involves the sale
of risk.
For DOPP purposes, it is an
offer by someone (risk taker) that,
if he is paid a certain amount (the
premium), he will pay out a certain
amount if he isn’t right that the
USDA-announced BFP will not
drop below a level set in the
contract.
Someone who sells “put"
options to farmers collects the pre
mium money in exchange for the
risk that he may have to pay out if
the actual BFP price is less than
what was projected in the put
option contract
The person who buys a put
option risks the loss of the pre
mium. (The level ranges, but gen
erally less than $1 per
hundredweight.)
The person who sells the put
option risks having to pay out the
full amount set in the put option.
For the fanner, the USDA con
siders the program to be risk
management
To understand the program, it is
essential to understand what the
federally determined Basic For
mula Price (BFP) is, and how it is
derived.
The USDA applies the formula,
and help with understanding it
should also be available through a
local Extension office.
Given that the BFP is under
stood, a farmer has to know his
cost of production and the relation
ship between the federally dec
lared BFP and his milk check.
The difference between the two
is the “basis.”
If, for example, a farmer's cost
of production is $l2 per hundred
weight, he may want to try to
ensure he captures that amount in
his actual paycheck, as a
minimum.
Or he may decide to lock in at a
lower level.
The reason to consider a lower
level of lock-in has to do with the
way the put options and the pre
miums are priced.
Futures traders can calculate
and anticipate BFP fairly well, and
are usually close to the actual
USDA-declared BFP.
The premium price for a put
option is based on the risk asso
ciated with the specific BFP price
declared in the contract
For example, if its January, and
April BFP futures contracts seem
to be settling around $12.50, a
range of put option contracts are
offered through the trading house
reflecting that $12.50 BFP level,
and several other levels, in 25-ccnt
increments, up and down.
Therefore, a buyer of a put
option has die ability to select a
BFP put option based on the
$12.50; as well as $12.75, $l3, or
$12.25, and $l2.
A LESSON
WELL
LEARNED...
LANCASTER
FARMING’S
CLASSIFIED
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GET RESULTS!
The premium on the put option
is what the fanner pays per hun
dredweight of milk volume to the
seller of the put option.
For example, the premium for a
put option at $12.50 may be
40-ccnts per hundredweight, and
30 cents for an option at $l2.
The farmer considering pur
chasing a put option to protect his
cash flow has to consider the fac
tors that influence the price of milk
and what the conditions ate that
affect those factors.
It's a guessing game.
If it seems that the BFP could
drop by $1 or more per hundred
weight below what the BFP futures
traders ate predicting through the
price they establish through trad
ing, then a dairy producer may
want to figure out how much of a
premium is reasonable to pay to
lock in a put option at an accept
able level of return.
Those who participate in DOPP
cannot use the government cost
share funds to purchase “put”
options at prices higher than the
projected basic formula price
(BFP) at the time of the purchase
of the option.
It works this way:
The futures market on BFP is set
according to what traders consider
will be the government-declared
BFP for a given month. That
amount changes with time and
events.
For a dairy producer, the put
options are paper-only contracts
whereby he pays a premium to the
right to sell his milk at a certain
BFP.
While the right to purchase such
opdons is open to anyone, the use
by dairy farmers is best advised to
be based upon actual production
and sales volume.
In essence, it works this way: If
the actual BFP is more than the
anticipated BFP specified in the
put cation, the farmer sells his
milk at the higher price and
receives nothing for the put option.
The cost of buying the put
option is to be incorporated as a
business expense, such as purchas-
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ing insurance, and therefore can be
deducted as a business expense.
The commission and premium
are lost, but that amount is small
compared to the protection that
could be afforded.
If the actual BFP is well below
the put option BFP, the farmer
sells his milk, but then he also
receives the cash from selling the
put option, protecting cash flow.
The milk check still comes from
the actual buyer of the milk. The
options check comes from the
commodity trading house.
During the meeting it was made
clear that those selling such put
options and those trading BFP
futures contracts are for the most
part shrewd and savy about daily
prices and trends and industry
influences.
The trading houses attatch pre
miums on the options, depending
upon the amount of risk.
A put option premium is
attatchcd to a range of BFP possi
ble prices available for purchase,
in 25-ccnt increments.
For example, if March BFP
futures were trading at $13.50, a
DOPP-participating fanner could
have purchased a put option on a
range of possible BFP prices
below $13.50.
(This is only through cost
sharing available through the
DOPP. In reality, a farmer could
purchase a higher put option, but
this government program is
designed for protections against
steep drops in BFP, not for profit.)
The DOPP program is designed
to allow fanners to set their own
price floor, starting at 25 cents
below the future option BFP and
going down in 25-cent increments.
(The lower the floor, the less the
premium.)
Holzhauer talked about his per
sonnal experiences and provided
his thoughts on the use of the put
options as a useable tool.
In brief, he said that the tool is
useful, but not all the time. It
should be used strategically,
instead of automatically, he said.
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