A look at the basics of maintaining a margin account for hedging milk and feed prices on an exchange.
By Katie Krupa, Rice Dairy
The increase in price volatility has sparked the need for many dairy producers to create risk management plans to maintain a viable business. Risk management plans are as diverse as the dairies implementing them, but many strategies involve hedging milk and feed prices on an exchange.
When a dairy farmer hedges on an exchange, he or she must fund and maintain a margin account. The term “margin account” refers to an account that must be funded when trading on an exchange.
When a dairy producer initially sells a contract to hedge his or her future milk price, he or she has to fund a margin account. This is called the “initial margin.” The initial margin is typically less than 15% of the full value of the contract and is similar to a deposit for the contract. It allows the buyer/seller to hold the contract. Regardless of whether someone is buying or selling a futures contract, the initial margin must be paid by both parties.
When placing a trade on the Chicago Mercantile Exchange (CME), the CME backs each trade, guaranteeing that the buyer and seller will pay or be paid what is due from the contract. Because the CME backs each trade, it requires both the buyer and seller to fund a margin account (initial margin) to secure the trade.
As the market fluctuates, the margin account must be maintained until the contract expires or is lifted. Since the trading prices for a given contract can move daily, the value of the contract can also change daily, and if the market moves against the contracted position, additional funds need to be added to the margin account. That payment is a maintenance margin, or more commonly termed “margin call.” The term “marked-to-market” refers to the daily margin account adjustment based on the current market price.
Every futures contract requires the buyer/seller to fund a margin account and deposit an initial margin when the trade is placed. Currently, a hedger in the dairy market will need to contribute $2,025 for every contract he buys or sells.
So, if a dairy producer hedged 200,000 lb. of milk per month for six months, the initial margin requirement would be $12,150 ($2,025 per contract x six months). After the initial margin is paid, the dairy producer will need to fund the margin account if the market moves against his hedge. The amount of funds required depends on the volatility of the market.
In addition to futures contracts, options can be used by dairy producers to protect against price volatility. The simplest strategy is to buy a put option. It offers price protection for a premium payment. For example, a producer could buy a $15.00 put option for $0.40 per cwt., which is $800 total for 200,000 lb. Because a put option protects the price from moving lower without limiting the upside, the producer will never have to add more money to the margin account (i.e., no margin calls).
Although there is no exact rule for how much a producer will need for a margin account or a hedge line of credit, a common rule of thumb is $2.00 per cwt. For a 1,000-cow dairy, producing 70 lb. per day, that is about $500,000 for 100% of the farm’s production for one year.
But as price volatility increases, typically the amount of funds in the hedge line of credit will need to increase to cover possible increases in both the initial margin requirements and possible margin calls. Buying put options is a great strategy for a producer with either no line of credit from his lender or a limited line of credit.
Historically, margin accounts and hedging have been misunderstood and subsequently avoided by many dairy farmers. Given current price volatility, many dairy businesses will need to create and implement a risk management plan in order to remain profitable and solvent.
For many, that means trading milk futures or options on the exchange and maintaining a margin account, and for the lender it often means providing a hedge line of credit. The good news is that there are various strategies available to dairy producers through brokers, co-ops, milk plants and government insurance.
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.Visit www.ricedairy.com.