Know Your Market
Can Your Hedge Strategy Weather the Volatility Storm?
Jun 05, 2011
Create a risk management plan that will work in any price cycle.
In recent weeks, Class III futures trading on the Chicago Mercantile Exchange (CME) have been climbing, causing many producers to nervously review and second-guess their current hedge strategy. Writing this on June 3, the June-August average Class III price has moved up more than $2.00 in just the past three weeks.
If producers hedged their milk price a month ago, they may be unsatisfied with their hedge strategy since futures prices are significantly higher. Many producers fear this situation, because money will potentially be left on the table. So how can a producer create a hedge strategy that will work in any price cycle?
1. Remember, hedging is risk management. You are not trading milk futures to “beat the market” or make a quick buck. You are working with a broker, coop or milk plant to hedge your milk price, and reduce your business’s risk from milk price volatility. When you set up your risk management strategy, use your farm’s financials to establish a price that will return an expected profit. Then make your risk management decisions based on financial reasons. Fear and greed should not influence your risk management decisions. Obviously, this is easier said than done. By making decisions based on financials, your risk management strategy should return your expected profit margin, and your business should be profitable regardless of market volatility.
2. Make decisions as a team. Regardless of whether your management team consists of just you and your spouse, or multiple partners and consultants, you should create your hedge strategy as a team. Now, this doesn’t mean that a management team of eight people need to make every trade decision, but the general risk management goal and philosophy should be agreed upon by the group. Sometimes the smaller the group, the harder the decision is to make. If it is just you and your spouse or relative, be sure that you are all on the same page, and communicate, communicate, communicate. Working as a team will help ensure the decisions are based on financials rather than emotions.
3. Game-play the hedge strategy. This is very simple but rarely done. When creating your hedge strategy, ask the following questions:
- What will my milk check look like if the Class III price settles at $9.00?
- What will my milk check look like if the Class III price settles at $25.00?
If you are uneasy with the answer to either one of these questions, look into different hedge strategies. There are many strategies that can protect the downside while still providing upside potential.
4. Be flexible. Unfortunately, the milk price can be influenced by a weather pattern, a political event or an act of terror. When these events occur, which won’t be projected in any forecast, you may need to adjust your hedge strategy. It is easy to put on the blinders and say the milk price will not go down to $9.00, or up to $25.00, but it can happen, and it can happen fast. Make sure your hedge strategy will suit your needs if the market changes drastically, or make sure you can change your strategy down the road. Don’t get locked into a hedge strategy that won’t work in a changing market.
5. Lastly, don’t lose sight of the big picture. Although you may leave some money on the table when the milk price moves up, you are creating a hedge strategy to protect your business should the milk price decline. Regardless of your chosen hedge strategy, there will inevitably be a time when the market moves and you give up some money. The good news is that this typically happens when the milk price is moving higher. Even though you have hedged a portion of your milk, a higher milk price for your un-hedged milk ultimately means more money in your pocket. And, yes, it hurts to miss out on higher prices, but it typically hurts the ego much more than the bank account.
Your risk management decisions should be viewed as long-term financial planning to protect your business and the families that depend on your business. Get educated, work with someone who understands your business, and create a strategy that can weather the volatile storm ahead.
Katie Krupa is the Director of Producer Services with Chicago-based Rice Dairy, a boutique brokerage firm offering guidance, analysis, and execution services on futures, options, spot and forward markets. If you are interested in learning more, Katie offers monthly webinars on the basics of risk management. You can reach Katie at firstname.lastname@example.org.Visit www.ricedairy.com.