Capture the Upside or Protect Your Profit?
Dec 17, 2012
Although no one likes to miss out on the market's upward movements, a strategy that protects the price from falling often means missing out on some of the market's upside.
By Katie Krupa, Rice Dairy
Last month I discussed the importance of consistency in your risk management strategy but noted that another key to a successful risk management plan in setting appropriate goals. When discussing risk management, I often hear dairymen say they “lost” money in their past risk management endeavors. When I hear that statement, it is typically because the producer’s goals and expectations were not properly established and reviewed.
When establishing a risk management strategy, your goal should be profitability for your business. Or, to put it another way, your goal should be to make money as a business (as opposed to simply making money on your trades/hedges). As a dairy producer, you produce a product, and you have a cost to make that product. Whenever you can sell that product for more than your cost to produce it, you make money. So your primary goal in risk management should be to receive a milk price that exceeds your cost of production. When you do this, you make money, even if that means you missed out on some upside potential in the market.
For example, you may have hedged your Class III milk price at $18.00 with a futures contract, so your price was fixed at $18.00. If your Class III equivalent cost of production was $17.00, that would be an estimated return of $1.00 per cwt. Now, if the Class III price settled at $10.00 or $25.00, you would still receive the $18.00 price, and still make money as a dairy business. Frequently, people think they are making money when the Class III price goes to $10.00 and losing money when the Class III price goes to $25.00. But in reality, you are making money in both situations because you hedged your milk price at $18.00, and your costs were $17.00. In this example, your goal was to make $1.00 per cwt. and to be profitable. That goal was met.
Rather than protect profit, your goal may be to protect yourself against devastatingly low milk prices. Most commonly this can be done by purchasing put options for Class III milk. A put option will provide a level of protection for a premium payment. If the milk price moves significantly lower, you will be protected, but if it moves higher, you will receive the higher price (less your premium payment).
Many think of this type of strategy as catastrophic insurance. Many times with this strategy, there is not much profit that is protected, but the goal is more often to protect the break-even, or even slightly below break-even at a sustainable level. Although this strategy allows for you to benefit from higher prices, you still need to pay the premium for the downside protection. At first, it may be frustrating to pay that premium when the milk prices are higher and you did not need the protection. But like an insurance policy, you pay the premium and hope not to use the coverage. If the milk price is higher than your level of coverage, that ultimately means more money in your milk check.
Although no one likes to miss out on the upward movements of the markets, when establishing a risk management strategy to protect the price from moving lower, it often means having to miss out on some of the market’s upside. It is important to remember that you made the decision to miss out on some upside because you need to protect against the downside and operate a profitable business. As the old saying goes, no one ever went broke making money. Keep your eye on the long-term goals, and keep running a profitable business and you will successfully remain in the dairy business.
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. You can reach Katie at firstname.lastname@example.org.Visit www.ricedairy.com. There is risk of loss trading commodity futures and options. Past results are not indicative of future results.