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December 2010 Archive for Know Your Market

RSS By: Dairy Today: Know Your Market, Dairy Today

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

Strategies for Tackling the Costs of Options

Dec 20, 2010

Dairy producers like the idea of having an insurance policy through puts and calls, but they don’t like the price tag. There are ways to combat this cost.

 
Spainhour PS jpegBy Jon Spainhour, Rice Dairy
 
In the past year, we have discussed several different futures and option strategies that dairy producers can employ when trying to establish a minimum price for their milk and a maximum price for the grain inputs. We have discussed fixed price contracts called futures and insurance type contracts called options. 
 
Within the discussion of options, we talked about different strategies that dairy producers can use, like buying puts, which establish a minimum price, or a floor, and leave the upside to market open for higher milk prices if they occur. We also talked about buying calls on our feed prices, which establish maximum prices for feed prices, while leaving the downside open if lower prices were to occur. 
 
One complaint producers have about strategies involving puts and calls is that they don’t want to spend the money associated with the strategy. They like the idea of having an insurance policy that protects them against the bad and allows them to benefit from the good, but they don’t like the price tag. Depending on the option, some strategies can be rather costly. 
 
One way we discussed for dairy producers to combat this cost of buying an insurance policy is to sell other options against their position. For instance, if a producer buys a $13.50/cwt. put, he may think about selling a $16.00/cwt. call against it. This strategy is often times called a risk reversal or a fence. By buying the $13.50/cwt. put, he has established a floor. 
 
However, that floor cost him a premium. By selling the $16.00/cwt. call, he established a ceiling for his milk at $16.00/cwt., but he collected a premium for doing so. By adding the call sale premium to this put buy premium, he has lowered the cost of protecting his downside. Of course, he has now limited his potential upside as well. The same can be done for his grain prices, only he is buying calls and selling puts.
 
Another strategy we have not discussed yet is what is commonly referred to as a put spread or a call spread. This strategy essentially involves establishing a floor at a higher level and then selling a floor at a lower level. For instance, a producer may want to protect himself against prices moving below $13.50/cwt., so he buys the $13.50 puts as discussed in the earlier example.
 
However, he may feel strongly that there is limited chance that the price of milk is going to go below $11.50/cwt. So he buys the $13.50/cwt puts and pays a premium while at the same time selling the $11.50/cwt. puts and collecting a premium. The net cost of protecting himself against $13.50/cwt. or lower milk has been reduced by selling the $11.50/cwt. puts. 
 
In this example, the producer has established a floor at $13.50/cwt. and is protected all the way down to $11.50/cwt. Below the $11.50/cwt. level, he is now exposed to the market again. This strategy is called a put spread. Producers can also use call spreads in the same way to protect themselves against rising grain prices. 
 
It should also be pointed out that, just like the fences we spoke about earlier, the secondary option doesn’t have to be sold at the same time you buy the initial protection. For example, a producer may buy the $13.50/cwt. puts while the market is moving lower. If the market does indeed move lower, the $11.50/cwt. puts are now worth more than they would have been earlier. He may wait until this point to sell them and get the better price. 
 
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 jcs@ricedairy.com.Visit www.ricedairy.com.
 

Prepare and Be More in Control, Less Vulnerable

Dec 06, 2010

Explore strategies that add flexibility while still removing price risk. If you do nothing, all you can do is watch and hope. If you prepare, you can retain some control over your milk and feed pricing.

 
S Schulla Bio PictureBy Steven Schalla, Stewart-Peterson
 
It’s the time of year when, as the temperature drops, many dairymen are coming inside to catch up on the “office” jobs that likely were pushed to the back-burner during harvest. That includes penciling out and putting together 2011 budgets. 
 
Many folks are telling me that while the past several months of higher prices have been beneficial, there has been little progress made from a financial recovery standpoint. Looking ahead to next year, we’ve heard a wide range of projected breakevens coming from different operations throughout the country. Figures have ranged from a base Class III price as low as $14.00/cwt. to as high as $17.00/cwt.  
 
Nearly all producers continue to struggle with high input costs, with corn, meal and even various by-product feeds continuing to hold at historically high levels.
 
Adding to the challenge, many bankers continue to tighten their lending standards, and current prices on the CME board for the first six month of 2011 look lackluster at best. 
 
As we study the current milk market fundamentals, there are still some positive indicators heading into next year. For example, year-to-date export figures for 2010 have been very strong, highlighted by a 63% increase in cheese and a 38% increase in whey shipped abroad compared to last year. National cow numbers have also remained basically steady through October despite much stronger milk prices.
 
On the other hand, cheese inventories continue to grow, and, over the past two USDA Cold Storage reports, have begun to grow at an increasingly fast rate. Cow productivity (milk per cow) has also shown sizeable increases throughout 2010, resulting in national milk production edging higher.
 
So, while there is some potential in next year’s outlook, the better strategy is to be prepared for both scenarios-- much lower or much higher prices than what is trading on the CME futures today.
 
What to do now?
 
At this time, marketers are in a most difficult situation. Any time milk prices are below breakeven and the risk appears to be for even lower prices, marketing decisions are more difficult to execute.
 
Referring back to our breakeven discussion, many of my clients acknowledge the risk of lower prices but are hesitant to make forward sales that would almost certainly lock in a loss. While this is a perfectly reasonable feeling, remember this: 
·                     While knowing our cost of production or goal price to achieve is very important for numerous reasons, focusing only on these figures when considering marketing decisions can be very dangerous. At times the market may never offer your desired price, and unfortunately, sometimes limiting a loss is a necessary thing to do. 
·                     There are also times when the market price far exceeds your desired price, providing unanticipated opportunity.
 
We believe that the current milk price situation is the ideal time to reach for some of the other marketing tools available to manage further downside risk, and also leave room to capture higher, more desirable prices. 
 
A simple example: By using a Put option strategy you can place a floor price to avoid a fall to back to lowest end milk prices, but only committing a fixed cost or premium that can easily be recovered if prices rally higher. A more advanced marketer may use a Short Fence (sometimes called a Min/Max) position to decrease the upfront premium cost by creating a window of prices they will receive for those pounds of milk. Both of these strategies will provide a minimum price while giving room to secure a higher price. 
 
I encourage you to explore some of these strategies to add flexibility while still removing price risk. If you do nothing, all you can do is watch and hope. If you prepare, you can retain some control over your milk and feed pricing.
 
--Steven Schalla is a Market Advisor for Stewart-Peterson Inc. He can be reached at 800.334.9779 or sschalla@stewart-peterson.com.
 
The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. Neither the information presented, nor any opinions expressed constitute a solicitation of the purchase or sale of any commodity. Those individuals acting on this information are responsible for their own actions. Commodity trading may not be suitable for all recipients of this report. Futures trading involves risk of loss and should be carefully considered before investing.  Past performance may not be indicative of future results. Any reproduction, republication or other use of the information and thoughts expressed herein, without the express written permission of Stewart-Peterson Inc., is strictly prohibited. Copyright 2010 Stewart-Peterson Inc. All rights reserved.
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