The Right Tool at the Right Time
Apr 04, 2011
While we can’t know with certainty what the market will do, we can resist our hardwired tendencies and put the odds in our favor while hedging. Here’s how to select the best available tool for a given market circumstance.
By Will Babler, First Capitol Risk Management, LLC
Our last “Know Your Market” article discussed hedging philosophy and risk management program objectives and expectations. The key takeaways from that article were:
· Philosophy - Dairy producers and other market participants can’t consistently out-guess the market over the long-term.
· Objectives - A good risk management program should focus on minimizing risk and capturing opportunity.
· Expectations - A consistently executed risk management plan isn’t intended to beat the market but rather smooth out earnings, support long term business planning and avoid emotional and financial stress.
Against this background, the next natural question from dairy producers is typically, “What tools are available to implement my plan, and when and how should I use them?”
A Hedger’s Toolbox
Dairy producers have firsthand experience in finding new and creative ways to fix things on their farms. An improvised ‘fix’ may get the job done in the short term, but to do things correctly often requires the right tools. The same principal applies when reaching into the hedger’s toolbox.
Fortunately for dairy producers, numerous cash market and futures and options tools are available to effectively mitigate risk and capture opportunity. Often the best place to start is in the cash market, where producers can typically utilize an array of cash forward contracts to lock in feed prices or lock in milk prices. The futures and options markets for corn, soybean meal and milk are also available to provide additional flexibility in protecting prices and margins.
Understanding the financing requirements for cash and futures tools is critical, but for this article we will first focus on when and why to utilize fixed price instruments (cash forward contracts, futures) and when and why to use minimum price or maximum price instruments (puts, calls). Moving forward, we will assume the mechanics of these instruments are understood, and first focus on how emotional biases impact hedging decisions by commodity market participants.
The cyclical nature of commodity markets brings with it the whole range of human emotions and biases – fear, greed, complacency, overconfidence, anger, elation, etc. These emotional responses to volatile markets often lead to sub-optimal, if not disastrous, market-related management decisions. In an effort to avoid these pitfalls, let’s take a look at the all-too-common thought processes of some commodity producers and their infamous last words during different market cycles:
· Low prices / Low margins – “The market has changed. Things are going to be tough for a long time. There is nothing I can do to improve things. I can’t take any more losses. I’m not going to do anything because I don’t think it can get any worse, --or-- I’m going to lock-in these poor margins because I can’t take any more pain and I don’t know what else to do.”
· Average prices / Average margins – “I wish the market was a little higher. I just read a report that things are going to improve. I’ll worry about hedging at some other time. “Right now, I’m doing fine and, besides, I have a big project I’m working on. I don’t need to consider hedging right now since I don’t think I have much risk. I wouldn’t be a producer if I didn’t think prices and margins were going to go higher.”
· High prices / High margins – “The market has changed. We have entered a new era, and demand is going to stay here forever. I don’t think supply is going to catch up any time soon. I don’t see anything that is going to knock this market off of its peak. I don’t need to hedge because things are only going to get better from here.”
Most of us can relate to these emotional responses to market cycles. Yet mean reversion drives booms and busts, and unfortunately this behavior usually results in doing exactly the wrong thing at exactly the wrong time. While we reiterate that we can’t know with certainty what the market is going to do, the following section looks at ways we can resist our hardwired tendencies and seek to put the odds in our favor while hedging.
Making the ‘Right’ Decisions
We’ve provided some examples of how extreme risk aversion, complacency and greed lead to poor risk management results. Here are some thoughts on attempting to work with the commodity market cycles to attempt to put the odds back in your favor. These concepts are also shown graphically in Figure 1.
· Low prices / Low margins – Recognize both that the market could go lower, but that over time the odds are that it will rebound. This points to taking minimum price and minimum margin positions to stop the bleeding but leaving plenty of room for upside. The positions selected should be for a shorter duration and for a lower premium. This approach avoids taking further losses and avoids extreme risk aversion that can prevent a producer from participating in the eventual upswing in prices and margins.
· Average prices / Average margins – Recognize that the market could move sharply in either direction. This indicates taking a blended position using both options and fixed price hedges, scaling in along the way. The hedges should be considered for a medium duration and should seek to minimize premium cost. Positions such as min/max options that provide a window of protection are often the best tool for keeping costs down, avoiding huge losses and keeping upside open for participation in improved margins. Maintaining consistent hedge coverage protects against the complacency associated with middle-of-the-road margins.
· High prices / High margins – Recognize that what goes up also comes down. The axiom that high prices are the best cure for high prices couldn’t be truer. When prices and margins reach extremely favorable levels, it doesn’t take long for producers to ramp up production and end users to reduce demand or seek out alternatives. This typically results in a sharp correction in prices and margins. Similarly, low prices and low margins reduce capacity and supply, thereby eventually creating a shortfall of production and appreciation in prices. Appreciating the cyclical nature of commodity markets keeps us from getting too greedy and allows us to lock in favorable margins over a longer duration using fixed price tools.
Conclusion – Providing Structure
Selecting the right tool at the right time is no easy task and comes with no guarantees. It certainly involves a deep understanding of the mechanics of each tool as well as a producer’s risk tolerance and financial capacity. Still, the conceptual issues discussed here should always be the starting point.
Another important aspect of applying the right tool at the right time is to do so consistently. We have found that this is best done by planning ahead and documenting objectives, limits and organizational control points in a written hedging policy.
In our next article, we will review the key contents of an effective risk management policy.