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October 2013 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.

How Much Do You Need USDA Data?

Oct 25, 2013

While USDA information is useful, it is you, the dairy producer, who still needs to make decisions in front of uncertainty and during fast market moves.

By Patrick Patton, Stewart-Peterson

Washington seems to have settled enough of its differences (at least temporarily), and for USDA and other government officials, it’s back to work. Your work didn’t stop nor did the markets stop moving. Therefore, we have to be confident making marketing decisions without the information we’re used to getting. With the political climate we’re in, it’s likely we’ll see government pull the plug again in the future. So let’s take a moment to consider how much that data really matters to dairy producers’ decision-making.

Now that USDA is back to work, there is one thing we can be sure of: Information will be plentiful. If you’re a news junky or believe that the markets move on each individual fundamental piece of data, you are probably very happy that you are once again due to receive most USDA data. We should be getting reports anywhere from the last week in October through the first week in November.

While it was a disappointment that the USDA closed most of its reporting, the market still moved onward. It is a wide variety of information -- whether it comes from the USDA, the latest weather forecast, or news of events elsewhere around the world – that impacts price movement. More often than not, the USDA reports simply serve as catalysts for movement; USDA adjusts its numbers and the market moves in a big hurry one direction or another.

Perhaps the lesson learned the last few weeks is, while the USDA information is useful, it is you, the dairy producer, who still needs to make decisions in front of uncertainty and during fast market moves. It is impossible to collect all of the world’s information and correctly predict which information will drive the market. Those producers who prepare and pre-plan, as well as those who execute regardless of price movement, will likely be more satisfied and in a position to control their own destiny.

One only has to look back the last half decade at all the major events that occurred and sent prices in very strong directional moves. None of these events were forecasted: the massive run-up in prices due to flooding, a runaway stock market in 2008, only to be followed by a huge economic collapse, a massive tsunami, a major drought and even a government shutdown. Though none were forecasted, they had to be dealt with. There’s no doubt that, in the future, there will be many more surprise events. Being prepared will be paramount for success.

I liken all this to dressing for the weather before you go out to work. If you wear multiple layers, you’re covered if the temperature goes up or down, or whether the terrain is smooth for walking or rocky and causes you to sweat. It doesn’t matter how many weather experts you consulted before you went out or which weather apps you have on your mobile device. All that matters is that you’re prepared for what actually happens.

For the dairy producer, that translates to a shift in activity around USDA report time. We typically spend more time preparing for the USDA reports prior to their release than we do reacting to the information they provide. We do this by looking at which reports historically have created the most volatility in the market, and what factors we are seeing from a technical standpoint leading up to the report. This technical analysis gives us a sense of some price targets the market could move toward.

The beauty of doing this in advance is that we can have conversations with producer clients in advance, discussing potential strategies, so that when the market actually does move, we can act quickly. We can act quickly because there is not such an emotional barrier to get through while the market is moving.

Whether you work with an advisor or not, preparation prior to a market-changing event is worth your time and energy. It sure beats back-tracking to find that extra layer of protection.
USDA is back to work and more information may be more readily available. It’s still up to you to plan and execute the strategies to shift risk and take advantage of opportunities.
Thanks to our Senior Market Advisor Bryan Doherty for contributing to this column.

Patrick Patton is Director of Client Services for Stewart-Peterson Inc., a commodity marketing consulting firm based in West Bend, Wis. You may reach Patrick at 800-334-9779, or email him at ppatton@stewart-peterson.com.

The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. This material has been prepared by a sales or trading employee or agent of Stewart-Peterson and is, or is in the nature of, promoting the use of marketing tools, including futures and options. Any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to Stewart-Peterson. 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. Copyright 2013 Stewart-Peterson Inc. All rights reserved.

Weighing the Costs and Benefits of Using Options

Oct 18, 2013

Options are perhaps the most desirable tools in many market profiles yet the least understood. CIH’s Chip Whalen explains when it makes sense to consider buying the put option over selling futures.

chip whalen thumbBy Chip Whalen, CIH

In managing forward profit margins, dairy producers have many contracting alternatives at their disposal in both their local cash market as well as through the use of exchange-traded derivatives.

When considering the latter class of choices, options are perhaps the most desirable under many market profiles yet the least understood. We often find that dairy producers as well as other livestock integrators and clients we work with struggle to understand option strategies and how they benefit their operations. While the space for this article is hardly adequate to answer all questions and bring clarity to a complex topic, I hopefully can help shed some light on a subject that is hard for most to comprehend.

Most of you are already probably aware that an option is a contract that conveys the right to buy or sell a commodity futures contract at a set price for a pre-determined period of time in consideration of a cost which is referred to as the option’s premium.

The option’s premium is a function of many components, including the price level at which the right to buy or sell exists, how much time remains to exercise this right to buy or sell, the price at which the underlying futures contract is trading at, and how volatile the price of this underlying futures contract has been historically.

One of the common objections to using options we often hear from producers is the cost of the premium. While it is true that options carry a cost, there is also a benefit that comes with them. When you purchase an option, you are not obligated to the price and therefore retain the opportunity for that price to improve in your favor. As an example, let’s consider a milk option for illustration purposes. Suppose I have just completed updating my financials such that I can determine my cost of production moving forward. For simplicity sake, let’s also assume I grow my own forages such that I know my feed costs and I can estimate my non-feed expenses with reasonable accuracy.

In this case, the main variable to my forward profit margin is going to be the price of milk. Although my mailbox check will include components and depend on utilization levels for the various classes of milk (let’s assume I am on the Federal Order), futures prices are going to be a large part of the overall variance in price between now and the time I eventually receive my milk check. Looking at Q2 of 2014, let’s assume I am projecting a forward profit margin of $1.30/cwt. This is based on the input cost of both feed and non-feed expenses I have already calculated, and the forward price of milk being projected by CME futures in that time period. Looking at the July Class III contract which would be the middle of that marketing period, the current price is just over $17.00/cwt.

As one alternative, I could simply "lock in" this price by selling a futures contract, and essentially establish a projected forward profit margin for Q2 at $1.30/cwt. (should my cost projections prove accurate along with non-milk revenue assumptions along with basis considerations for components, PPD, etc).

Another alternative would be to purchase the right to sell futures at $17.00/cwt. by buying a put option at that strike price, which is currently offered at $0.80/cwt. in the July contract, representing the midpoint of that Q2 marketing period. With this strategy, I am essentially protecting a minimum milk price of $16.20/cwt., and by extension, a minimum profit margin of $0.50/cwt. ($1.30 gross profit margin minus $0.80 put option premium).

Given that the feed costs are already known in our example -- since we grow our own forages and we are comfortable with the other cost and revenue projections -- let us now focus strictly on the milk price. The main contractual difference between "locking in" a price of $17.00 and protecting the $17.00 price level as a floor is that in the former case we are obligated to the price whereas in the latter case we are not, we simply have the right to sell at that level. The question therefore becomes under what scenario are we better off choosing to sell futures over buying a put option? The answer is we are better off buying the put if the price moves higher; specifically, by more than the amount that we pay for the premium of this option. While somewhat counterintuitive, we want the put to depreciate and lose money.

As many of you may also already know, when you purchase an option, you can lose the entire premium paid for the right which was purchased. In the above scenario, if we spend 80 cents to purchase a milk put that gives us the right to sell futures at $17.00 cwt., the worst case scenario is that we lose all the premium which is paid for in full at the time the option is purchased. The cost therefore is fairly straightforward – the most the option is ever going to be is 80 cents. What’s the benefit? We retain the opportunity for milk prices to appreciate in a rising market, therefore preserving the potential to sell our milk at a higher level and receive a larger milk check.

Where the benefit outweighs the cost is when the milk has appreciated by more than what we paid for this benefit. While somewhat simplistic, one question you might ask yourself when evaluating the merits of the two strategy alternatives is whether or not you believe July Class III Milk futures will eventually be higher than $17.80/cwt. between now and expiration of the contract. If the answer to this question is yes, then it may well make sense to consider buying the put option over selling futures.

You might be reading this and think that if I have a bullish bias towards price, wouldn’t I be better off doing nothing and simply staying open to the market on my milk price risk? While this may be true, the reality is that none of us can know for sure what is going to happen between now and next July. At least with buying the option, I know my worst-case scenario, which, in this example, is a positive margin of $0.50/cwt. That may help you and your family sleep better at night and bring greater comfort to your dairy operation. I suppose while we are on the topic of weighing costs and benefits, another reasonable question to ask is what is that benefit worth?

As Vice President of Education & Research at CIH, Chip Whalen is responsible for developing and conducting all of CIH’s Margin Management seminars. He is also the editor of CIH’s popular Margin Watch newsletters. Whalen can be reached at (312) 596-7755 or cwhalen@cihedging.com. 

The Portfolio Approach to Risk Management

Oct 14, 2013

With this strategy, the idea is to make smaller, more frequent decisions regarding marketing. LGM for Dairy can be a part of that.

ron mortensen photo 11 05   CopyBy Ron Mortensen, Dairy Gross Margin, LLC and Advantage Agricultural Strategies, Ltd.

The problem with managing risk is that, almost by definition, one cannot predict anything about the next risk. One cannot predict when it will occur or how large it will be. For example, it’s hard to predict the timing of rainfall and heat in the summer—factors that affect pollination. Many farmers will buy a package of seed corn varieties with different maturities. Most would not plant the same corn hybrid maturity across all their fields. Farmers spread out maturities and pollination times to spread out risks. They plant a corn portfolio--something similar to a financial portfolio at a bank or other financial institution.

For dairymen, the portfolio approach speaks to marketing strategy. The idea is to make smaller, more frequent decisions regarding marketing. This certainly is better than trying to hit the year’s high in milk prices (where, of course, everyone says they will sell 100% of their production) and the lows in prices for any feed purchased. It’s a nice goal but not a practical goal.

Ever since USDA’s Livestock Gross Margin for Dairy (LGM-Dairy) program started six years ago, we thought it would make sense to buy multiple policies. For example, purchase three to six months of coverage on 10% to 25% of your milk production every month. This way you would be building a portfolio of coverage. You are reducing risk by spreading your risk.

If you look back, you can see buying multiple polices with three to six months coverage would have given you better risk management than just buying one long-term policy.
Mortensen graph 10 14 13

Guide to the chart

The chart above represents potential LGM-Dairy policies that could have been purchased starting in January 2012 and ending December 2012. The chart shows a zero-deductible policy. The coverage would have started in March 2012 and ended in November 2013. In the spirit of full disclosure, policies were not available in 2012 until October (the government subsidy money had run out). Currently, there is subsidy money available and policies have been purchased every month so far in 2013.

The green line is the CME Class III milk price. The black line is the Actual Gross Margin (AGM). This is a combination of the actual settlement prices of milk, corn and meal used in calculating possible LGM indemnities. Please note the AGM tracks with the CME class III milk. This highlights the most important factor in LGM calculations—the milk price.

Each of the other colored lines represents a policy’s Estimated Gross Margin (EGM) that could have been written. EGM is the guarantee for that month.

When the black line (AGM) is below the colored line of the policy, an indemnity for the month would have been calculated.

For example, the bright blue line shows a policy that was purchased in October 2012. The first month of coverage would be December 2012. For this period, every month had an indemnity except May 2013.

LGM-Dairy Review

LGM-Dairy is an insurance policy which guarantees the difference between milk prices (Class III on CME) and feed prices (CBOT corn and soybean meal prices). It is designed and underwritten by the USDA/RMA. Essentially, it is backed by the government, just like crop insurance is for corn, soybeans, wheat and other crops. This is a way to guarantee cash flow for up to 10 months.

Simply, LGM-Dairy manages the risk of rising feed costs and falling milk prices. LGM-Dairy does not guarantee milk production. It guarantees a level of protection from changes in milk prices and feed prices.

For example, if the price of milk (Class III) goes up and feed goes down, you will not get an indemnity payment. If milk prices go down and feed prices go up, you will get a payment depending on how big a deductible you used. LGM-Dairy manages the price changes or the margin. Remember, the milk price is based on the CME price, not your mailbox price.

LGM-Dairy is very similar to using options. The difference is that LGM-Dairy is subsidized if you buy protection covering two or more months. The subsidies range from 18% for a zero-deductible policy to 50% for the $1.10 deductible. LGM-Dairy is like buying a milk put, a corn call and a soybean meal call. Policies are cheaper when they last for more months and/or if their deductibles are increased. If you compare milk, corn and meal options to LGM-Dairy, the insurance product can be as much as $.60 per cwt. cheaper.

Ron Mortensen is principal of Dairy Gross Margin, LLC, an agency that specializes in LGM-Dairy products, and owner of Advantage Agricultural Strategies, Ltd., a commodity trading advisor. Contact him at ron@dairygrossmargin.com or visit www.dairygrossmargin.com.

Buying Put Options to Protect your Milk Price, Your Business and Your Sanity

Oct 07, 2013

Dairies that have avoided buying put options because of their premium cost need to re-think that approach, says dairy broker Katie Krupa.

Katie Krupa photoBy Katie Krupa, Rice Dairy

Yes, you’ve heard me talk about buying put options before, but this article has a little different spin. I’ve talked to many dairy producers who have avoided buying put options because of the premium cost associated with the options. While I am not out to change anyone’s mind, I would like to challenge you to think about things a little differently.

Firstly, if your risk management plan is to utilize your equity position and/or relationship with your lender to manage through the price volatility, you may not need to do anything else for your risk management planning. Although this strategy is not an option for most dairymen, this is a suitable strategy for those who can manage the price volatility themselves (self-insure) with little financial stress to their business or personal stress to themselves and their families.

For the rest of you, I would start your risk management planning by looking at put options. Put options are appealing to many producers because you are able to protect the milk price from declining significantly without limiting the upside potential. Simply put, you pay a premium and get a level of price protection. Although put options are not insurance, the concept is similar, and most producers can better understand how put options work by thinking of them as insurance for the milk price.

The first complaint I often hear is, "I’m tired of paying all this money and getting nothing back." Although the concept of price protection seems good at first, after buying put options for some time and having the milk price settle above your strike price (so no payment is received from your purchased put option), many producers will begin to think that they should be "getting something back" for the money they used to purchase those put options.

While I can understand your desire to "get money," in this situation that’s the last thing you want to happen. If you purchase a $17.00 Class III put option for $0.40 and the Class III milk price settles at $14.00, your net Class III price is roughly $16.60 ($17.00 put, less $0.40 premium, less other possible brokerage or cooperative fees). But if the Class III price settles at $20.00, your net Class III price is roughly $19.60 ($20.00 price, less $0.40 premium, less other possible brokerage or cooperative fees). Which is better for your business: $16.60 or $19.60?

Obviously $19.60 is better than $16.60, but I know many of you are thinking that you would have been better off doing nothing because then you wouldn’t have the expense of put options, and your net Class III milk price would have been $20.00. Yes, you are correct. But, unfortunately, no one knows when the milk price will be $12.00 or $20.00, so you need to plan for either situation. Similar to insurance, you buy it, but you don’t want to use it!

Producers who consistently purchase put options will often say they’re buying more than price protection -- they are also buying peace of mind. How frequently do you worry about the future of the milk price -- couple times a month, a couple times a week, a couple times a day? If you worry about the milk price more frequently than you would like, you probably need a better risk management strategy. I can think of many producers who consistently buy put options because getting that level of price protection helps them better manage their dairy, and helps them sleep better too!

Lastly, many producers will say, "I want to buy put options but they are too expensive." Yes, these can seem expensive, but the reality of the level of price protection, peace of mind and ability to make longer-term decisions for your dairy may more than make up for the price. You have to look at risk management as a cost of running your business. It’s not fun or glamorous, but it may keep your business viable, regardless of high or low prices. Add risk management into your budget and make it part of your monthly expenses to protect the future of your business.

Katie Krupa is a broker 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 Katie at klk@ricedairy.com.Visit www.ricedairy.com. There is risk of loss trading commodity futures and options. Past results are not indicative of future results.

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