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Know Your Market

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

Tried and Failed at Hedging? Reconsider Your Approach

Nov 19, 2012

If you’ve tried hedging in the past and haven’t had the best experience, think again. You may be surprised by all the options that are available.

Katie Krupa photoBy Katie Krupa, Rice Dairy

I recently attended an industry meeting with many successful dairy producers, and to my surprise, when the topic came to risk management, many of them made a similar comment: Tried it once or twice, but never made any money. Sound familiar?

I am always alarmed to hear about producers who ‘tried’ contracting once or twice. This type of statement indicates that their risk management approach was spotty and spontaneous rather than planned and consistent. It also indicates an expectation that is inconsistent with hedging. In order to be successful with risk management, there are several steps producers should follow. Appropriate goals and consistency are among the most important. In this month’s article, I will address the importance of consistency. Next month, we’ll tackle the topic of appropriate goals and expectations.

A good risk management plan should set up your business to be profitable, account for volatility in both the milk and feed markets, and be consistently utilized and reviewed. Unfortunately, many producers who tried hedging in the past have not truly set up a risk management plan. Instead, they simply hedged their milk price because they thought it looked good (with no reference to their cost of production), or the hedged price was higher than the price they were currently receiving, or the price was 20 cents higher than what the neighbor hedged.

Unfortunately, these strategies usually don’t end well. You should be hedging a price that works for your farm’s unique financial situation, you should be managing both your milk and feed risks, and you should be consistently reviewing your plan.

It is important to note that being consistent does not mean always being hedged. You may review your financials and the current market conditions and determine that your best strategy is to remain in the cash market, i.e., not hedge. Even though you are not hedging, you are still utilizing your risk management strategy, and therefore being consistent.

To illustrate the importance of consistency, I have pulled some historical data for Class III put options trading on the Chicago Mercantile Exchange since 2007. The table shows the premium prices for a $13.00, $14.00, and $15.00 put strike price. In order to add some uniformity, I pulled the price for the contract month six months into the future, and I did that every six months. So, on the first trading day in April, I took the prices for October, and on the first trading day in October, I took the prices for the following April. Although this data does not account for every trading month, it does give a good snapshot of the historical prices.

A producer using this strategy would have paid an average of 15 cents per cwt. for the $13.00 put, or 36 cents for the $14.00 put, or 77 cents for the $15.00 put. The bottom half of the chart shows the payment that would have resulted from these contracts. As you can see, there would have been no payments in October 2007 because the announced Class III price of $18.70 was higher than all the put strike prices ($13, $14, and $15). For the months shown below, the only months that would have had a return are during 2009 and early 2010. That is just three out of the 11 months in the table. Although the puts were only in the money (payment due) for three months, the payment amounts were substantial. In fact, the payments in those three months were large enough to result in a positive net gain for the $13.00 put and $14.00 put, and a breakeven for the $15.00 put for all 11 months of data.

I like this chart because it shows how quickly the market can change. If this producer had utilized put options for 2007 and 2008 but not for 2009, he or she would not have had protection when it was most needed. Unfortunately, even the best analysts cannot guarantee the future, so it is important to plan for both the highs and the lows.

If you have ‘tried’ hedging in the past and have not had the best experience, I recommend sitting down with a professional to reevaluate your risks. You may be surprised by all the risk management options that are currently available, and you may find a risk management approach that will suit your business and your personality so that you can consistently protect your operation and survive well into the future.

Krupa chart 11 19 12 copy

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. You can reach Katie at klk@ricedairy.com.Visit www.ricedairy.com. There is risk of loss trading commodity futures and options. Past results are not indicative of future results.
 

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