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Know Your Market

RSS By: Dairy Today: Know Your Market, Dairy Today

Dairy trading experts offer strategies and practical perspectives to optimize market performance.

Strategies that Make Sense

Mar 19, 2012

Sometimes it makes sense to use forward contracts or futures, like buying put options and selling calls on milk.

 
ron mortensen photo 11 05   CopyBy Ron Mortensen, Dairy Gross Margin LLC
 
Back to basics. Protect the stakeholders. Pay the bills. Get to next year. Just get to next month. Marketing plan. Business plan. Cash flow statement. Defend and protect. Guarantee cash flow. Keep the marketing plan simple.
 
We all have had these types of discussions with ourselves. We may have even these discussions with our spouse, our children, our employees and even a few of these with our lenders. Sometimes in the business cycle, we should look at using different types of strategies. Sometimes it makes sense to defend cash flow. Sometimes it makes sense to do nothing. Sometimes it makes sense to use forward contracts or futures.  
 
Think about how to defend cash flow and defend net worth. Option strategies can be used to add to previous sales. They can be used to protect cash flow and net worth. Option strategies can be used to get closer to 30%, 50%, 75% or 90% total coverage without creating a lot of risk. Options, used in combination with a forward contract or futures, tend to reduce risk if prices go lower and also reduce risk of selling too much if prices go higher. 
 
Strategy I
 
Buying put options on milk can be the tool to give you a floor price but not put a cap on profits. Your risk is the premium you pay for the put option. You will not lose any additional money except for the premium.
 
When do you use this strategy? When you cannot lock in profits of if costs are above the futures prices. If you sell, you will be locking in losses. What do you cheer for? Prices to go higher. The put option may turn out to be worthless, but if milk prices rally, your cash flow will be better.
 
If you review an August Class III milk chart, you will see two important areas--$16.00 and $16.70. Look at buying puts with strike prices at one of these support areas.      
 
August Milk Put  
Futures Price     $16.78/cwt (as of March 16, 2012)
Put Strike price $16.75  
Premium              - $.97
Floor Price           $15.78
 
Second choice with the lower strike price:
Futures Price     $16.78/cwt (as of March 16, 2012)
Put Strike price $16.00  
Premium              - $.63
Floor Price           $15.37
 
Strategy II
 
Buying put options and selling calls on milk can be the tool to give you a floor price and a ceiling price. The ideal time to use this strategy is if the put price is near your break-even. In addition, the call option you sell would allow you to sell milk at a profitable level that meets your financial goals.   
 
This strategy will be a little cheaper than just buying a put option. However, it will be marginable. In other words, if you put this trade in your account, you will be subject to putting in additional margin money. If the market moves higher, you will need to fund your account. What do you want to cheer for? Prices to go higher and settle just below the call option you sold. In this case, below a settlement price of $18.49 would be optimal. You may have had a few margin calls, but prices rallied and you sold your milk at a higher price.    
 
August Milk Put/Call Spread
Futures Price     $16.78/cwt (as of March 16, 2012)
Put Strike price $16.75  
Put Premium      - $.97
Call premium     + $.40
Floor Price           $16.18
 
Call strike price $18.50
Put Premium     - $.97
Call premium     + $.40
Ceiling Price        $17.93
Net cost              $ .57
 
Feed Insights
 
USDA once again released information regarding U.S. and world supply/demand. It was a yawner for the US data. The world data showed smaller soybean crops for Brazil and Argentina.
 
The big surprises will be coming on March 30 when the USDA releases the Grain Stocks report. Especially important is the corn stocks number. USDA has had a tough time with this number in the past. Look for lots of volatility in the days after this number. The second report that day is Prospective Plantings. Private firms have now estimated as high as 95.5 million acres to be planted to corn. This would be a big crop if there are trend-type yields. On the other hand, it looks like the U.S. may need to plant an additional 1 or 2 million acres of soybeans to offset the reduced production in South America.
 
Ron Mortensen is one of the founders of Dairy Gross Margin, LLC, which was formed in 2006 to sell Livestock Gross Margin Insurance to dairy producers. Mortensen’s firm is now licensed in 23 states. He is also president of Advantage Agricultural Strategies, Ltd., which he founded in 1985, to provide individual risk management advice for farmers and agribusiness using futures, options and cash trading strategies. Contact him at 515-570-5265 or ron@advantageag.com.
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