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Options: From the classroom to the calendar

Mike North Published on 30 September 2015

Einstein was quoted as saying “In theory, theory and practice are the same. In practice, they are not.” We have spent several articles discussing the “how-to’s” and “what-for’s” of options as it pertains to hedging milk and feed in the futures and options arena.

We have walked through a few examples of how these tools can be put to work in your operation. It is now time to evaluate the current market environment to find where and how they can be applied in 2016.

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After all, marketing and risk management are about looking into the future to manage the unknown with the limited information that exists today. We must move our understanding from the classroom to the calendar.

The first step in this process is to evaluate your own resources, limitations and preferences. We spent some time talking about market dynamics, but just as important (and more so) are the dairy operations and the people behind them.

It is really easy to talk about strategies, but the person/people employing a strategy need to possess the necessary resources to support the strategy, be on board with the decision and be comfortable with its potential outcomes.

For example, I have historically heard many producers who have little or no experience using market tools comment on their plan to ride out the highs and lows in the market and use their equity as the means to weather the storm.

After coming through a period of drawdowns in their equity, those same individuals will comment that cash is tight, operating lines are maxed out, they have accumulated greater debt, are now unable to make capital investments into their operation, carry out their business plan or even do simple things like take a vacation.

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They wanted to use their equity as leverage, but realized later that they were not happy with the outcome of their plan. Alternate strategies require the same consideration.

Before employing option strategies, some important considerations should be made relative to each strategy. How much will it cost? Are there additional cash-flow requirements that may come as a result of using this strategy? What amount of risk am I covering?

Are there limitations in my future market opportunities that are created by using this strategy? Is the timing or environment right to employ such a strategy? Am I comfortable with these additional requirements or limitations? These are all questions that should be asked and thought through in advance.

On more than one occasion, I have had producers reach out to me after reading a periodical, brochure or other piece of marketing literature that suggested or explained a particular market strategy.

While there is likely nothing wrong with the strategy in question, the producer likely has not weighed out all of the variables that we are discussing.

On occasion, that producer will later tell me they put the strategy into place only to learn later about some of its nuances, or that they themselves were not mentally prepared to walk through the potential outcomes. It is worth taking the time to evaluate your own capacity to manage a strategy and its different variables before entering into it.

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It is time to move out of our discussion of theory to evaluate opportunities that can be captured in practice. First, let’s talk feed. One of the interesting dynamics of our industry is that every part of the country has access to different feedstuffs for their ration.

Regardless of the variety, the goal is to move the right balance of the appropriate nutrients into the cow to maximize health and performance. From a hedging perspective, we are faced with a dilemma relative to the long list of ingredients available to our nutritionists, that being how to manage the price of each of these components without a matching futures contract.

While the correlation is not exactly perfect, there are strong relationships between the values of corn and soybean meal and the many different available products that work their way into the rumen.

With that in mind, we can boil down the many different pieces into a corn and soybean meal equivalent so as to create a “hedgeable” quantity of each which can be managed with futures and options.

Since corn makes up a large part of most rations, the corn ingredients correlate quite nicely. However, with other products, we recognize that rising prices of corn and soybean meal nearly always translates into higher cost of other components despite the lack of perfect correlation.

Use of corn and soybean meal futures and options allows us, then, to manage our approximate ration cost. So let’s look closer at 2016 and some different obstacles and opportunities being presented and some solutions to take advantage of current conditions using the options market.

At the time of this writing, corn and soybean meal prices are near the lowest levels seen all year. Silage harvest is only weeks away for much of the country. The USDA just raised yield estimates of corn and soybeans in their recent report.

Corn crop conditions are holding near one of the highest summer levels we have witnessed in several decades. With all of this information at our disposal, we still do not have absolute understanding of where markets will go – but can draw a few assumptions.

We can expect growing ending stocks to keep a degree of pressure on prices. This, of course, can change as yield is continually evaluated or the quantity of corn and soybean demand adjusts relative to price. Many dairymen are caught between the hope of lower prices and the opportunity of current prices.

This is where option strategies create some real value. You might recall that a call option offers the buyer the right to buy a particular commodity at an established price. The cost to purchase such a right will vary with the amount of time you wish to hold that right.

At present, you can purchase call options at a level of $4 per bushel on corn and $330 per ton on soybean meal for a cost of $0.18 per bushel and $11 per ton respectively to provide you protection from rising prices into May.

Your maximum exposure with such a strategy is the premium you paid for the options plus your transaction costs. There will be no additional premium or capital required to maintain it.

If prices should continue lower, you are afforded the opportunity to purchase your feed needs at lower relative levels than where prices are currently. However, if prices rise, you are holding protection from those higher levels in the form of a call option.

Of course, there are other considerations. One of those considerations is availability. While the USDA projects strong national yields, that is not to say that all parts of the country are doing great. There are most certainly areas where crops aren’t so great.

If you find yourself in a place where the availability of feed will be an issue, it is important to secure the physical product. While a call option does wonderful things on paper, cows don’t make milk from paper transactions. You need feed.

Given the current scenario, you are very much recommended to secure product and create the security in your operation that the cows will be fed. In this case, you can purchase the feed and then apply a put strategy to afford you further access to lower prices should they come.

At present, you can purchase put options at a level of $3.70 on corn and $300 per ton on soybean meal for a cost of $0.22 per bushel and $14 per ton respectively to provide you access to lower prices into May. Again, your maximum exposure with such a strategy is the premium you paid for the options plus your transaction costs.

There will be no additional premium or capital required to maintain it. If prices fall dramatically, you can sell your put options, collect the gains in premium and use them to reduce the cost of the feed you have secured.

On the milk side of things, prices have certainly not been strong enough to “wow” producers. With price averages for the year just north of $16 on a Class III basis and just south of $15 on a Class IV basis, many have cold feet about addressing next year’s market.

However, does the lack of excitement excuse the possibility of lower prices down the road? Certainly not. With large world supplies of powder, devaluation of Chinese currency, content buyers, struggling economies and ongoing milk production growth, there are plenty of dark clouds on the horizon.

As we analyze prices relative to history, we recognize that we stand near the middle of our 10-year price range. That said, many do not know what to do. Again, this is a fine place to put options to work. With that in mind, there are several strategies to consider. We will take a look at two.

The most basic of all strategies would be to purchase put options throughout the coming calendar year. At the time of this writing, $15 Class III puts are available for $0.70 per hundredweight (cwt). Class IV markets are offering a $14 put for $0.75 per cwt at the time of this writing.

As previously discussed, the coverage allows you any upside price opportunity that may develop while providing coverage for you at your chosen level. Given that many are reluctant to spend that kind of premium for their coverage (understandably so), there are others to consider.

One that works well in this environment is that of a min/max strategy. The benefit in the current market is that you can achieve a higher level of coverage for less immediate premium than an outright put. The catch is that you introduce a cap to your opportunity and will have to margin the strategy once in place. We discussed this in my last article.

Now let’s give it a 2016 focus. You purchase a Class III $15.50 put to provide you coverage near the current market and protect you from downside price action. You sell the $19 call to help pay for the put.

You are now capped throughout 2016 at a level of $19 per cwt. The cost (at the time of writing) to enter into such a strategy is $0.60 per cwt. You are able to maintain a level of coverage near the market while still entertaining a near-$3-per-cwt move (on average) to higher prices.

Said differently, you may be capped at $19 per cwt, but you have given yourself a great deal of room to capitalize on prices while enjoying coverage very near to current price offerings. This type of strategy takes the pressure off of you to pick the exact perfect time to enter into a contract and opens the door to better opportunities.

As discussed previously, there will be margin associated with this strategy, so consult your market adviser before entering into such a strategy.

We have spent a great deal of time hashing over the intricacies of option markets and how to deploy them in your risk management efforts. As always, remember to balance your actions when managing input costs and milk revenue. If you need assistance in working through that, feel free to contact me with any questions you might have.

All of these exercises are meant to help you expand your understanding of the often-mysterious application of options. But don’t let your budding education of these instruments stop with simple instruction.

Take them out of the classroom and get busy looking out into the calendar to put them to work. Lean on your risk management adviser to help you.  PD

Disclaimer: The information contained herein is the opinion of the writer or was obtained from sources cited herein. It should be noted that the impact on market prices due to seasonal or market cycles and current news events may be reflected in market prices. Trading in futures products entails risks of loss which must be understood prior to trading and may not be appropriate for all investors.

Mike North
  • Mike North

  • President
  • Commodity Risk Management Group

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