For any futures price equal to or lower than the strike price, the dairy producer lets the option expire having no value. The call option is worthless because it has a loss built into it equal to the difference between the futures price and the strike price. In this case, the option expires having no value and the buyer forfeits the premium paid for the option. One of the keys to hedging is knowing your basis. Historical basis data for your area is vital to implementing a hedge that meets your needs.
Basis does fluctuate, but usually follows a seasonal trend throughout the year.
It is advisable to allow room in your pre-hedge analysis for the actual basis to deviate some from your estimate. A problem that often arises with buying a call option is that the option premium is higher than you can justify. A window strategy for protecting the cost of farm and ranch inputs involves simultaneously buying a call option and selling a put option. For example, you can choose strike prices so that the premium received from the put option totally offsets the cost of the call option, establishes a price ceiling that at least allows you to have a positive cash flow, or any other possible objective you may want to achieve with your window strategy. The window, or the range between the price ceiling and the floor price, is determined by these two strike prices.