Tips for Hedging without a Large Upfront Investment
May 06, 2012
Three strategies to reduce your margin account funding requirements -- or even eliminate them all together.
By Katie Krupa, Rice Dairy
In recent months, milk prices have declined, and producers across the country are starting to feel the pinch.
The 2011 average Class III price was $18.36, which compares to the January-April 2012 average price of $16.14. Unfortunately, the short term outlook doesn’t look any better. The Class III futures for May-August 2012 are currently averaging around $14.75.
Because of this downturn, many dairy producers are looking into risk management strategies and are concerned with the need to fund a margin account when working with a broker. Below are some strategies to consider to reduce your margin account funding requirements or even eliminate them all together.
1. Buy put options through a broker.
When you buy put options, you are getting a level of price protection for a set amount of premium. If you are buying put options through a broker, you will need to pay the full premium amount (for all months you are contracting) upfront, but you will not be required to add more money to your account if the market should change. This allows you to protect your milk price for a set amount of money, and, if the milk price increases, you’ll be able to benefit from the higher price (and you won’t have to add more money to your brokerage account).
For example, a July-December $14.00 put option costing around 30 cents would require you to contribute around $3,600 ($.30 x 2000 cwt. x 6) to your brokerage account for 200,000 pounds of milk per month.
Another strategy is to purchase what’s commonly called a ‘put spread.’ When you purchase a put spread, you are actually buying a put, and at the same time selling a put at a lower level. This strategy offers limited price protection. It works well for some producers because they are able to get a higher level of price protection for a lower premium, but the protection is limited. If the price drastically declines, the producer would only be protected for a portion of the decline.
For example, a July-December $15.00/$14.00 put spread (buying the $15.00 put, and selling the $14.00 put) costing around 35 cents would require you to contribute around $4,200 ($.35 x 2000 cwt. x 6) to your brokerage account for 200,000 pounds of milk per month. This strategy offers price protection between $15.00 and $14.00, but nothing below $14.00. So, if the Class III price should settle at $12.00, you only gain the $1.00 between ($15.00 and $14.00) less the 35 cent premium and brokerage commissions and fees. Again, with this strategy, you will never have to add more money to your brokerage account because if the price should decline, your gains from the $15.00 put will offset your losses from the $14.00 put.
2. Hedge through your cooperative or milk plant.
Several cooperatives and milk plants offer risk management hedging opportunities for their dairy producers. While some only allow you to fix your price, others have diverse milk contract offerings and even feed hedging strategies. When hedging through co-ops or milk plants, typically no money is due upfront; rather, any money owed or due is adjusted in the milk check for the month the milk is contracted. This allows producers to hedge their milk (or even feed) without having to lay out funds upfront.
3. Take advantage of Livestock Gross Margin Insurance (LGM) when you can.
Since this option is not currently available, I will keep this short. LGM offers coverage on the milk-feed margin for one month or a series of months, and a premium payment is due. The nice thing is that the premium payment is due at the end of the insured months. Unfortunately, however, funding for the program has been fully utilized, so producers cannot currently use this strategy.
Regardless of your cash availability, there may be an option or multiple options available. I suggest connecting with a professional to assess your risk management needs, available hedging options and funding sources.
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.Visitwww.ricedairy.com. There is risk of loss trading commodity futures and options. Past results are not indicative of future results.