Know Your Market
Developing a Relationship with Your Broker
Oct 25, 2010
Hedging certainly isn’t rocket science, but it is likely something that you have never done before. Your relationship and communication with your broker can determine how successful your hedging career will be.
By Jon Spainhour, Rice Dairy
During the last 10 months, I have described some of the underlying fundamentals associated with dairy price risk management. We have discussed fixed-price contracts called futures and insurance-like contracts called puts and calls.
We discussed how those contracts can be used to establish minimum output prices and maximum input prices for our dairy and commodity prices. We have discussed the importance of knowing our breakeven prices on the farm and how we can use different strategies to protect those levels.
We even discussed the importance of having a well-financed hedge line of credit so that we don’t have to rely on our “cash on hand” to meet margin calls, which can sometimes outpace our cash flow schedules. Finally, we discussed the importance of developing a sound hedging policy and remaining committed to it, as opposed to jumping in and out of the market simply because the market is moving against us.
For many, this litany of points makes common sense and, while unfamiliar with the market particulars, they are still able to grasp the importance of hedging and the underlying mechanics of how a hedging plan would work. However, they are still uncomfortable about how to actually get started.
In an earlier column, we discussed that one of the first steps in this whole process is to locate a broker and establish a relationship with him or her. While the field of brokers dedicated to dairy risk management is not as robust as other markets like the grains, there are several brokerage houses that do dedicate the majority of their time and efforts to dairy futures and options.
My suggestion is to contact each one of them and explain where you are at in your hedging career. Do not be afraid to tell them that you do not know what you are doing. If you do know what you are doing, great! But if you don’t, it is nothing to be embarrassed about. The majority of the brokers you will speak with have no idea how to milk a cow. Don’t be embarrassed that you don’t know how to use their products.
Once you overcome this psychological hurdle, ask the broker to help educate you further. Spend time with him or her on the phone. Ask for educational material. Go to their educational seminars. Don’t be afraid to let him or her know there is something that you don’t understand. Ask questions. Most of all, though, force the broker to understand the economics of your operation. Every farm is different, and every farmer has a different outlook on what his risk profile should be and how he would like to manage it.
At the same point in time, it also your responsibility to put in the work on your end to ensure that you understand the material at hand as well. Hedging certainly isn’t rocket science, but it is likely something that you have never done before. Your broker can help educate you and understand your operation, but he can’t force you to put in the front-end work needed to get you started hedging.
Once you’ve interviewed several brokers and found the one you feel the most comfortable with, you will need to open an account and fund it. Once you have proven to yourself and your broker that you feel comfortable with hedging and have sound expectations and an even sounder hedging policy, you then need to decide what kind of relationship you want to have with your broker.
Do you want to be active in the futures market every day and rely on your broker for their market insight? Or do you simply want to find the cheapest, most risk-averse hedging strategy you can find and be done with it?
I personally have dairy producer clients whom I speak with every day and others that I speak with once a quarter. The frequency of the communications is based entirely on their hedging strategy and style. There is no reason to speak with your broker every day if you have simply bought puts against your expected breakeven levels, but there is also no reason to put on a very active futures position and not speak with your broker for weeks at a time, especially if you are relying on them for their market insight.
Some clients even go so far as to turn their hedging over completely to their broker and enter into what is called a “Power of Attorney” arrangement. This relationship is not for everyone and should not be entered into lightly. Under this arrangement, once a producer demonstrates he understands hedging and its risks and benefits, he communicates his hedging strategy to his broker and allows his broker to take care of the details.
In any case, your relationship and communication with your broker is likely what is going to determine how successful your hedging career will be. Each relationship will be different, but make sure you develop that relationship and stick with it. Like all good relationships, they can be hard, but it will be worth it in end.
Jon Spainhour is a broker/trader 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 Spainhour at firstname.lastname@example.org.Visit www.ricedairy.com.