Know Your Market
Using Options to Manage Dairy Financial Opportunity
Mar 04, 2012
Taking a fixed position is a bold action and requires conviction and courage. Options are a remedy for greed and fear. They are available and do work, but they have a premium cost and limitations.
By Carl Babler, First Capitol Ag
As we have candid and honest discussions with dairymen nationwide, we learn that one reason marketing decisions are not taken is fear.
The fear of missing out on a better price opportunity after contracting to sell milk or buy corn is real. Fixed price commodity positions are just that -- fixed, set, final and unchangeable commitments to a given price, revenue and margin. When a dairy producer contracts for a fixed price, knowing he or she will not receive a worse price, that usually does not offset his or her fear of not getting a better price. Thus, the decision to do nothing is taken.
Greed, or the desire for more, is common to all mankind. Dairy marketers do have commodity options that can effectively help satisfy their desire for a better opportunity. Options, when used to hedge a fixed commodity position, can provide extra opportunity if price moves against a fixed position.
How does this strategy work?
A dairy sells milk for a fixed price with its processor and simultaneously buys Class III call options equal to volume and term of its plant contract. If the milk price during the term of the fixed price contract moves to higher levels, the call option position can capture a part of the higher price opportunity.
A dairy buys corn on a forward contract and simultaneously buys corn put options. The use of put options following a contract to purchase corn is also functional if the corn price would drop after the corn purchase price is fixed by contract.
Dairy margin example - In June 2008, the price of corn for 2009 was at $7 futures, and the 2009 price of Class III milk averaged over $20. To manage the margin, it required a dairy to sell milk and simultaneously buy corn. Many people close to these commodities advised dairies to buy $7 corn because they believed the corn market was going higher, and not to sell milk because they felt the milk price had to go higher as well. As a result, many dairymen, in fear of missing out on a better margin, accepted the risk of doing nothing.
Let us look at how options could have fit in:
Buy the $7.00 corn to lock in the corn price, and buy corn put options to cover the bushels contracted for the forward period involved. The corn puts would gain equity if the corn price would fall to lower prices after contracting at $7.
Sell the $20 milk, and buy milk call options to cover the pounds contracted for the forward period involved. The call options would gain equity if the milk price continued to move higher after being fixed at $20.
The above actions protected a margin, with the options providing opportunity for additional profitability if corn dropped and the milk price increased. These options have a premium consummate with the price levels protected. Options used to open the door of improved financial opportunity have a cost that must be budgeted and deemed affordable. However, they are available, they do work and they can be a practical remedy to greed and fear.
Dairymen who had acquired an understanding and proper expectation of options did in fact use this strategy when corn was $7 and milk was $20. They then were in a position to capture an improved margin opportunity when, in July 2009, milk futures prices dropped to $10.90/cwt. and corn fell to $3.50/bu.
Looking backward at what would or could have been may be helpful, but the real question is what can be done now?
Options can be used to manage margin risk and allow a dairy to be open to improved margin opportunity if the corn price drops and the milk price improves. With current feed prices and Class III milk averaging $16.25 for July through December 2012, margins are currently at or below breakeven in the West and moderate in the Midwest. Buying call options to cover the risk of a higher corn price while buying milk puts to manage the risk of a lower milk price for the period July 2012 through Dec 2012 is possible. The options manage margins against a decline while allowing room for upside participation. You are not locked into a corn or milk price; you only have taken an option position.
In conclusion, taking a fixed position is a bold action and requires conviction and courage. Options are a remedy for greed and fear. Options are available and do work, but they have a premium cost and limitations. Dairy producers have come to an improved understanding of the usefulness of dairy options and are using these tools to open themselves to improved price and margin opportunities. An 800-word discussion cannot cover this topic in its entirety, but if your interest has been stirred as to how to manage opportunity after a contract position is established, we invite your inquiry.
Carl B. Babler is a consultant and senior hedge specialist with First Capitol Ag in Galena, Ill. He has been involved in the futures industry as a broker, educator and hedger since 1975. Babler holds master’s degree from the University of Wisconsin-Platteville and completed agribusiness course work at Harvard University. You can reach him at 1-800-884-8290 or firstname.lastname@example.org.