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

Look Beyond This Summer’s Strong Milk Prices to Plan and Protect

Sep 02, 2011

It’s time to think about using some of the current income from higher milk prices to establish your risk management strategy for future months.

 
Katie Krupa photoBy Katie Krupa, Rice Dairy
 
The start of a new school year means crisp new books, pens, a clean backpack and, most notably, a fresh start. A fresh start to put your best foot forward, not get behind in your work, and maybe keep that new backpack relatively clean. With the milk price peaking and fall approaching, there are numerous similarities between the current dairy situation and a new school year.
 
Dairymen have had several good months of milk prices, and in spite of rising input costs, a lot of folks have some extra money in their pocket. The extra money can be used to pay down debt, update facilities or equipment, or even buy a shiny new tractor. Now is the time dairymen have the opportunity for a fresh start: get on good terms with the lender by paying down debt, upgrade the farm and make the facilities a little more modern and efficient, and buy some new tools.
 
A fresh start should also include a risk management strategy to avoid potential troubles down the road. With a new school year comes a new study schedule, a strict bedtime, a health check-up and other preparations to be well prepared and healthy for the year ahead.
 
Dairy farmers should be doing the same for their business. Set schedules for workers, projects, and payments, get the farm healthy by making necessary updates, and most importantly make preparations to avoid potentially hazardous situations. One very hazardous situation is a decrease in revenue due to declining milk prices and/or increasing feed costs.
 
Over the past several years, many dairymen have steered away from risk management strategies because their desired strategy may have a cost or require funds be utilized upfront. Now is the time to think about using a portion of the current income from higher milk prices to establish your risk management strategy for future months.
 
One popular strategy where this works is buying put options for Class III milk. This strategy allows the dairy producer to protect his or her Class III price at a desired level for an upfront premium payment. The premium payment is made, and the milk price is protected. If the milk price should move higher, the producer will not miss out on those higher prices, just the premium payment.
 
Additionally, the current milk prices enable many dairymen to protect their business’ breakeven (some can even protect a profit margin). I suggest working with a professional to review your farm financials and establish a risk management strategy for both milk price and feed costs that will enable your business to maintain profitability in future months.
 
Many dairymen are overwhelmed by the idea of doing these calculations on their own. If you fall into that category, find a professional who is familiar with these types of calculations and use their service. Due to historically high milk prices and the numerous risk management strategies that are currently available to dairy producers, now is a great time to review your options.
 
We don’t know what this new school year – or the milk market -- will bring, but we can take proactive steps to protect against potential hazards down the road. We don’t know if the 2012 milk price will be more like 2009 or 2011, but you have the opportunity to prevent a 2009-like milk pricing year for your farm. If the milk price should decline drastically a risk management strategy can protect your profitability and your operation.
 
As the kids head out to school with their new cloths, crisp supplies and, hopefully, smiling faces, they are equipped and ready to bring home good grades even if they hit some bumps in the road. As the cows head out to milk, the farm managers should be preparing the business to be profitable in the future, regardless of potential price volatility.
 
From the numbers I review, this summer has been profitable for dairymen. Now is the time to get a fresh start and review strategies to protect profits for the future.
 
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 klk@ricedairy.com.Visit www.ricedairy.com.
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COMMENTS (1 Comments)

PA dairy - PA
Put options are a good tool for dairymen to consider, however they must be fully understood. Options are derivatives of the underlying futures contract. Options premiums trade the strike price time value violtility. Premiums need to be analyzed using these three factors. We cannot accurately model violtility but time value definitely can be managed. Plotting the time value of a premium as an option reaches expiration reveals an exponential loss in premium (time value) as you approach the option contract month. This can be managed as the large loss in premium value is a loss to you the option buyer. Consider buying a put option and examinining historic trends of the time point when the premium drops off exponentially. At this point, we need to examine if we should offset the put option by selling our option premium and replacing it with a much cheaper foward contract. However, if the option is in the money, hold the option. But simply blindly using put options as risk management strategy can be pricey considering the exponential loss that always occurs in the time value of the premium you purchased.
9:57 AM Sep 2nd
 

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