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Dairy trading experts offer strategies and practical perspectives to optimize market performance.

Wade into the Feed-Price Protection Pool

Dec 09, 2013

New to risk management? One simple way to get started is to use call options to lock in some protection for feed.

Scott Stewart   CopyBy Scott Stewart, CEO, Stewart-Peterson Inc.

While attending the Elite Producer Business Conference last month, I was struck by a new sentiment among some of the dairy producers I talked with. They recognized they ought to be doing something to protect themselves against market risk; they just are not sure where to start.

Hesitation to get started marketing is nothing new. The twist here was that these producers had the perception that engaging in marketing was a big risk, like a jump off a high dive into the deep end of the pool. They feared taking a big jump, and as a result they were not doing anything. I fear for these producers, because effective risk and opportunity management is key to surviving and thriving in this new era of volatility.

Producers only have to get their feet wet to get started. It’s not necessary to go "all in" on your marketing when you’re first getting started. In fact, it isn’t advisable if you do not know what you are doing. When markets are volatile, you need to either be an expert or hire one.

You don’t develop expertise overnight. A high diver likely waded into the shallow end of the pool when he first learned to swim. If any of this describes you, and you are thinking about wading into the waters of risk management, here are some thoughts for getting started.

Feed prices are at some of the most attractive levels we’ve seen. Corn is down approximately 50% from its high of $8.44 last summer. In fact, corn has been down 10 months in a row, and down 15 out of the last 16 months. From a technical standpoint, that is quite a sell-off, making the market very susceptible to a severe upward correction. In addition, there are several fundamental reasons to believe that the risk of the corn price going higher from here outweighs the opportunity of the corn price going much lower from here. These reasons include demand renewal, export commitments and ramped-up ethanol production.

Now would be a great time to lock in some protection for feed. One simple way to get started is to use call options.

Let’s say you need to purchase 5,000 bushels of corn on April 1. Between now and then, the price of corn, and therefore your cost, could be much higher. Since the April 1 price of corn is currently unknown, your risk is effectively unknown as well. A simple means of limiting and defining your risk is to buy a call option that will protect you from higher prices until the time you purchase your corn feed. If the price of corn does indeed go higher, the option gives you the right to purchase corn at a lower price sometime in the future (plus commission and fees and the cost of the option). If the price of corn goes lower, our option would likely be worthless; however, for a relatively small price, we have given ourselves protection against a big risk of higher prices.

Now, options have all sorts of layered strategy opportunities that allow you to take advantage of any volatility that might be in the market. I would not advise anyone to try these tools until you are comfortable with the simple strategies. Just know that these tools exist, and the purpose for using them is to gradually, over time, bring down your overall cost for feed while protecting yourself from big price run-ups that drain your profitability.

Now is the time to ask questions and learn. Whoever you choose to work with for the above positions, make sure you understand the advice, communicate well with your advisor, and trust the advisor. Develop a relationship during the learning process. Expect that you will be educated and made to feel comfortable along the way.

No matter what tools you choose to apply in your beginning stages, be consistent in following through to the end result. Moving in and out of positions will not help you learn; it only will cost you money. Consistency means 100% commitment to following through on your agreed-upon strategy, even when a news headline or a second guess tempts you to abandon your position. On the other hand, know that 100% commitment to marketing does not mean you have to risk all of your production. It simply means you will follow through on your strategies and give them fair evaluation. Often times, fair evaluation takes time to unfold, underscoring the importance of sticking-to-it despite emotions.

Feed is the number-one cost center on your dairy, and fortunately, it is one of the easiest places to dip your toe into the price risk management waters. We suggest that you test the waters now, before a price correction hits and you are learning in a high-price, high-pressure environment.

S P Corn Chart 12 6 13 a
This chart shows corn’s large price decline from the summer high of $8.44. The front month contract has come down to reach a long-term uptrend line of support drawn using the 2005 and 2009 lows.The probability of this upward trend line holding through the middle of next year outweighs the probability of the market falling substantially below this trend line.

 

Scott Stewart is CEO of Stewart-Peterson Inc., a commodity marketing consulting firm based in West Bend, Wis. You may reach Scott at 800-334-9779, or email him at scotts@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.

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