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Know Your Market

RSS By: Dairy Today: Know Your Market, Dairy Today

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

Risk Management Is Also About Opportunity Management

Jul 19, 2010

By Steven Schalla, Stewart-Peterson

 

We know from history that commodity markets are generally cyclical. For example, the milk market has seen cycles of 30-40 months from low point to low point, with different influences in each cycle. In general, markets are always seeking a supply and demand balance, and therefore, they are cyclical.

 

Because the markets spend a fair amount of time in the area of low prices (with the past 18 months inordinately low and prolonged), you as a producer of a commodity deserve to get the best possible price you can when prices trend upward.

 

It’s not realistic that you’ll always be able to sell your milk for the top price the market offers. No one can consistently predict the top. My point is this: As prices strengthen, don’t be so focused on RISK management that you forget about OPPORTUNITY management.

 

Over the past two weeks, we’ve seen a fairly aggressive rally in third-quarter milk prices, supported by hot and humid weather throughout the country (expected supply decreases) and higher cheese prices (demand increases). As a result, several of our third-quarter months are climbing to the $15 price level. That’s been a pretty elusive number, and many dairy producers are undoubtedly thinking, “I better get going and sell.”

 

The emotion of the situation can be compounded by pressures from other influencers, such as bankers, spouse, and business partners, all of whom are anxious to lock in a price for positive cash flow.

 

If the financial situation of your operation requires you to sell as soon as prices rally to assure cash flow and stop bleeding, that’s fine. There are certainly dairies that require this kind of risk protection. Yet even in this situation, it’s always good to explore how you can add a little bit of flexibility into your milk marketing.

 

If your financial situation and risk tolerance allows for a little more creative thinking, you could look at a variety of pricing strategies and see what impact each strategy has on your overall price. Remember, in a comprehensive marketing approach, each decision works toward building the best possible weighted average price over time.

 

Let’s look at a couple of strategies and see what impact our decisions have on our overall price received if any number of different market scenarios unfold:

The first strategy is a simple forward contract position, selling milk at $15. It is a fixed position, guaranteeing the $15 price even if prices fall, but giving you no opportunity to participate in potentially higher prices.

 

The second strategy combines a forward contract with call options. The purpose of call options is to protect against the really big price jump by allowing us to participate in a price rally, even though we already have milk sold at a “good” price of $15 through the forward contract. You really start to see the benefit of this tool if the market hits $16 or beyond.

 

The third strategy does not use a forward contract; rather, it uses a put option at a cost of 25 cents to give us a minimum price of $14.25 and no ceiling as prices climb.

 

After reviewing the effect of each strategy in various price scenarios, we then need to decide which strategy is best for our situation. If you are a highly leveraged dairy with cash flow stress right now, you may need the forward contract. If you are an operation with a fairly strong equity position and can withstand the risk of a $14.25 floor price, then you may want to use put options to give yourself the best upside opportunity.

 

It comes down to reviewing the scenarios, knowing your financial goals, understanding what you (and other influencers around you) can stomach, and deciding which strategy will perform the best for you.

 

Which price scenario will unfold this fall? No one can say for sure. Technical analysis would tell us that prices should be strengthening through the fall, and patience and planning could mean opportunity. That’s the reason I’m addressing this topic now, so you can realize opportunity if the market rallies. (Heaven knows, you’ve borne some of the worst prices in the cycle.)

 

No one knows exactly what the market will do, but you can be ready for whatever scenario the market dishes out.


 

Market Scenario Planningsm Summary

Strategy

Weighted Average Price Impact in Each Price Scenario

$12.00

$13.00

$14.00

$15.00

$16.00

$17.00

Forward Contract September milk at $15.00

15.00

15.00

15.00

15.00

15.00

15.00

Forward Contract September milk at $15 and buy Call Options ($15.75 call option at cost of 25 cents)

14.75

14.75

14.75

14.75

15.00

16.00

Purchase Put Options covering September milk ($14.50  put option at cost of 25 cents)

14.25

14.25

14.25

14.75

15.75

16.75

 

Steven Schalla is a Market Advisor for Stewart-Peterson Inc. He can be reached at 800.334.9779 or sschalla@stewart-peterson.com.


Market Scenario PlanningSM is a service mark of Stewart-Peterson Inc.

 

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 2010 Stewart-Peterson Inc. All rights reserved.

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COMMENTS (3 Comments)


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11:12 AM Oct 29th
 

So true. Honesty and eveyrhting recognized.
6:57 PM Oct 27th
 

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