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What Is the Real Price of Playing the Odds?

Nov 30, 2012

Getting caught up in “lottery ticket” emotion is what causes many dairies to leave so much at risk.

Stewart Peterson   Mark LudtkeBy Mark Ludtke, Stewart-Peterson

As I write this column, the organizers of the multistate Powerball lottery are waiting for two lucky people to claim one of the largest prizes in lottery history. I already checked my ticket. I didn’t win. And chances are you didn’t either if you are reading this column right now.

Lotteries can be a fun conversation piece because they get people thinking and talking about what they would do if their life suddenly changed overnight with a mindboggling amount of money. The bigger the jackpot, the more the buzz, and the more people buy tickets pushing the jackpot even higher.

So my odds of winning were something like 1 in 176 million. That’s crazy. When I go buy my ticket wearing my rational hat, I know I’m not going to win.

When a dairy producer is evaluating whether or not to price milk or feed, you have to wear your rational hat as well. That’s not always easy to do, because the dollars involved in establishing a marketing approach are so different from the way we think about our operating dollars. Let me illustrate using some round numbers:

The owner of a 2,500-cow dairy operation produces 700,000 cwt. at $20/cwt., giving him about $14 million in revenue to manage. He considers a risk management approach that would require him, due to the size of his operation, to put up about $1 million in margin money. He could secure that through a line of credit that is separate from his operating line, and that $1 million would be available to secure the lion’s share of the $14 million.

But he likes the milk price where it is. All the fundamentals point to the milk price staying where it is. He thinks about that $1 million in margin money and thinks about what he could do with $1 million if it was operating money and he didn’t “spend” it on marketing.

The risk is this: If the milk price were to drop to $15/cwt., he would be giving up more than $4 million in revenue. That’s a real loss, as opposed to the $1 million in margin money, which is there to secure positions as needed.

This producer has gotten caught up thinking about what the $1 million hedge line of credit means and lost sight of the real dollars at risk. It’s difficult to keep our rational hat firmly in place when the markets are abuzz and prices are good.

Numbers can play tricks with our minds in other ways, too. Let’s say you are trying to protect your price for protein purchases. The trading range for protein has been in the $300-$550 range. After careful management and incremental marketing strategies throughout the year, you are now sitting with a $325 average price for your 2012 protein purchases. You are well within the bottom 20% of the range, and much lower than what your price could have been had you not carefully managed your purchases. You’re pretty happy with that.

On the flip side, if the trading range for milk for the year is $15-$20, and you manage to build a weighted average price of $19, you kick yourself for having achieved “only” $19,” even though $19 is in the top 20% of the trading range. You see the deduction on the milk check and start thinking about what those “lost” dollars could have bought.

It’s this kind of emotion that causes so many dairies to leave so much at risk. True, when prices are high, you may be giving up some real money to protect risk, but as a percent of gross and net, what you give up is not nearly as impactful as what you have at risk. It is the price of protection in this economically uncertain world.

I’ll end with a note from Jim Collins’ best-selling business book, Great by Choice, which I have been quoting regularly in this column. Collins’ observation of successful companies shows that they are successful because they “engage directly with evidence rather than relying upon opinion, whim, conventional wisdom or emotion.” Understanding the empirical evidence is a safeguard against making emotional decisions.

So if you know that your chances of winning the lottery are 1 in 176 million, and you are wearing your rational hat, you probably won’t buy a ticket. (Unless you are buying something else with that $2, like the opportunity to joke and talk about dreams with others who joined in the hoopla.)
If you’d like a copy of Collins’ book Great by Choice, I’ll be happy to send you one if you email me. Just don’t rib me about buying a lottery ticket. Compared to those who didn’t buy one, I had a 100% better chance of winning!

Mark Ludtke consults with dairy producers nationwide concerning their choices for risk and opportunity management. He can be reached by calling 855.334.0700 or at mludtke@stewart-peterson.com.

The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. Neither the information presented, nor any opinions expressed constitute a solicitation of the purchase or sale of any commodity. Those individuals acting on this information are responsible for their own actions. 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. Any reproduction, republication or other use of the information and thoughts expressed herein, without the express written permission of Stewart-Peterson Inc., is strictly prohibited. Copyright 2012 Stewart-Peterson Inc. All rights reserved.
 

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