December 28, 2016

Know Your Options

Top Story  |   |  By: Mike North

As markets become more volatile and dairies get bigger, it’s becoming more imperative for producers to look at all the risk management tools available in the toolbox. Many producers are accustomed to contracting feed and might have taken the initiative to also contract milk. While this is certainly one approach, the marketing strategies I encourage producers to consider are largely built around options. There are many strategies out there, but options can provide flexibility in an uncertain market.

In contrast, futures give us absolutes. We can sell futures or contract milk and know exactly what price we will receive for our milk. While it gives you certainty, it takes away opportunity. Options give you the flexibility to manage downside risk while retaining ability to participate in market upticks. Even if producers pursue the use of futures or contracting, include an options strategy with it to regain some opportunity. Here are a few basic options strategies:

Buy A Put. The most basic approach to managing downside risk is to buy a put. With a put in place, downside price risk has been attended to, and by default you are still able to participate in potential rising prices. This strategy is one of the best approaches for someone new to the marketplace. The one element of that transaction that needs to be balanced is the premium cost. That’s where other strategies come in. However, if you decide to find a way around the cost of a basic put option, be sure to balance the price you pay on the front end with opportunity cost on the back end.

Min./Max. With this strategy you are basically buying a put and selling a call option. Such a pairing allows you to either cheapen the cost of the put or raise the level of coverage while sticking to the original budget. However, it is important to recognize such a move puts a ceiling on your milk price. What’s different about that ceiling compared to just selling your milk is the ceiling should be higher than the current marketplace. For example, right now we can buy a $17 put and sell a $19 call for limited cost. So for a producer whose cost of production is $15 per cwt, this might become a consideration when looking to protect profitability. The compromise is you have placed a ceiling on your milk. Any rallies in price above that ceiling will be outside of your reach. Entering such a transaction does require margin, so cash flow is a consideration. Consult your adviser on such things.

Synthetic Put. If contracting with your milk buyer is still your preferred means to manage price, let me challenge you to consider the addition of a call strategy. For example, if you desire to capture the current market by selling milk at $17.40, you could then buy a call option above that, say at $18.50. You’d capture the current price, have a call option roughly $1 above that, and if the market made an incredible move higher you’d still be able to participate in any move above $18.50 per cwt. The only upward price outcomes that would remain inaccessible to you would be between $17.40 and $18.50.

Amid current volatility any of these strategies will provide downside coverage and some degree of upside opportunity. Possible strategies are endless with options. Find a strategy that fits you and the current market well.