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Higher Milk Prices, Lower Hedge Level? Spare Yourself the Second-guessing

Sep 27, 2010

Milk prices are climbing and, if you hedged your milk at lower prices, it’s easy to feel frustrated that you sold it too cheap. But it’s important to remember why you made the decision to hedge your milk when you did.

 
By Jon Spainhour, Rice Dairy
 
Over the course of the last few months, we have discussed how dairy producers can use tools like futures and options to help manage their bottom line. By using these tools, producers can lock in their output price of milk and, at the same time, lock in a good portion of their variable input prices like corn and soymeal.
 
We have also discussed the idea of making sure that you hedge both of these variables of a profitable hedging equation at the same time so that you are not locking in the price of your milk while leaving your input price open ended, or vice versa.
 
One aspect of hedging that we haven't discussed so far is the idea of consistency, or making sure that after you have developed a successful hedging strategy, that you stick to it and not try and out-guess the market or pick and choose what months or contracts you are going to hedge.
 
It seems especially important to discuss this issue during times like these, when the milk price has made such drastic moves higher. It is easy for a dairy producer who hedged their milk at lower prices to feel as if his sold his milk too cheap and feel frustrated. “Why did I sell my milk so cheap?” is the question they are likely to ask themselves.
 
While it is certainly an understandable concern, as no one likes to leave money on the table, it is important to remember why you made the decision to hedge your milk when you did. More than likely, you were hedging a milk price that made sense to your bottom line in terms of it helping you establish a profitable operating margin.  
 
After you calculated your cost of doing business in terms of your variable input prices and measuring those prices against your potential milk future price, you contracted both sets of variables either with futures or options. That decision was based on your desire to lock in a profit margin, not to try and outguess the market.
 
While it is true that milk prices are likely higher at this point than they were when you established your milk hedges earlier in the year, that does not mean that you have made a mistake or been an unsuccessful hedger. The fact of the matter is that prices could have gone the other way and moved to lower levels.
 
The point is that it is easy to feel that you have sold your milk too low. You may feel that the next time it comes around to hedging, you may only hedge your inputs only or do no hedging at all. I believe that this would be the wrong decision and that time after time, in commodity after commodity, the perils of this decision have been experienced. Almost as soon as someone alters his or her successfully developed hedging plan, the market turns the other way and over corrects, causing drastic results.
 
The key to successful hedging is to develop a hedging plan that fits your appropriate risk parameters as it relates to your overall profitability, implement that plan, and then stick with it. While there may be some times that money gets left on the table, having the knowledge that you will be in business in the future should compensate for that tax.
 
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.
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