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Dairy Futures and Options: Consider Class IV

May 24, 2013

There are three notable trends in the Class IV market that dairy producers should take into account.

Carl BablerBy Carl Babler, Atten Babler Commodities LLC
 
Since the launch of dairy futures by the Chicago Mercantile Exchange (CME) in 1996, the majority of attention, trading volume and risk management strategies have revolved around Class III milk contracts.
 
Approximately 60% of U.S. Federal Order milk production is used to produce cheese, thus the expected emphasis on Class III Milk. Early on, the CME provided risk management education directed toward producers and processors of Class III Milk. Dairy producers nationwide began a journey along a continuing futures- and options-based risk-management learning curve that featured Class III contracts. Even California Order producers found the Class III contract as a useful means to manage price risk on the cheese portion of their milk check.
 
The Class III futures contracts have been the primary hedge tool that allows processors to offer producers contracting programs. In addition, Class III options have provided both producers and processors various strategies to place boundaries on price risk. Class III futures, Class III puts, Class III calls -- everything Class III has led the way of dairy futures and options products.

Class IV milk, the milk used in the production of butter and nonfat dry milk, is also listed on the CME with active futures and options contracts. This is a lesser known market to most producers, but it is one that should be better understood by those in certain regions of the country, especially in California. Current Class IV prices, the volatile profit margin environment and increased interest from producers, processors and end-users have recently spurred increased activity in Class IV trading.

Class IV Liquidity
 

Class IV contract liquidity has recently improved as shown in Figure 1 below. This provides California producers the ability to capture opportunities offered by the volatile butter and powder market, markets that increasingly reflect the growing export interest in these commodities. California producers now are able to manage components beyond cheese value in their milk price. Producers can combine Class III and Class IV futures contracts to minimize basis risk and protect all of the components of their California overbase price.

The improved liquidity in the Class IV options market in particular has provided producers the opportunity to establish minimum price (long put options) and min/max (fence – long puts/short calls) positions for a known net option premium. Class IV contracts are also providing effective hedge instruments for producer in other regions of the country were milk checks are significantly driven by butter and powder value. Note the increase in trade volume of Class IV futures since the start of 2011 as shown in Figure 1 below.


Babler graph 1   5 24 13Figure 1 (right) – Class IV Futures Liquidity
Source: FuturesSource

Class IV Trends

There are three notable trends in the Class IV market that producers should now be considering:

1. Class IV volume and open interest, while not at their historical peak, are trending higher. Higher volume and open interest in the past have been associated with high Class IV milk prices. This relationship between high prices and higher trading activity is a benefit to producers that wish to protect favorable prices and margins and need the liquidity to do so.

2. During most past periods, the Class IV market has traded at a discount to Class III as shown in Figure 2 below. Currently, the spread has reversed, with Class IV trading at a premium to Class III across the next year. This historical abnormality should be considered as an opportunity for producers to protect the relative value of their Class IV exposure.

3. Class IV option trading has recently picked up pace and now offers a viable opportunity for producers to increase their hedging flexibility. Option volume recently hit a multi-year high as shown in Figure 3 below. Producers who are currently engaged in the Class IV option market have been able to make use of a wide variety of strategies, including outright long puts, put spreads, min/max positions and three-way spreads.

Babler graph 2   5 24 14
Figure 2 (right) – Class III vs. Class IV Pricing
Source: FutureSource


Babler graph 3   5 24 13Moving Forward

Producers are advised to explore the availability, liquidity and opportunities to use Class IV futures and options contracts to better manage their specific risks. Doing so can reduce the basis risk between milk check prices and the ultimate settlement values in their hedging account when the appropriate ratios of Class III and Class IV are taken into account. Understanding the implications of complementing Class III positions with Class IV futures and options products should be explored with an experienced dairy commodity risk manager.

Figure 3 (above) – Class IV Futures & Options Volume
Source: CME

Risk in purchasing options is the option premium paid plus transaction. Selling futures and/or options leaves you vulnerable to unlimited risk. Atten Babler Commodities LLC uses sources that they believe to be reliable, but they cannot warrant the accuracy of any of the data included in this report. Past performance is not indicative of future results. The author of this piece currently hedges for his own account and has financial interest in the derivative products mentioned within: Class III milk.

Carl Babler is a principal with Atten Babler Commodities of Galena, Ill. Contact him atcbabler@attenbabler.com or 877-259-6087.

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