Dairy Price Risk Management Session 8: Where to from Here?

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Dairy Price Risk ManagementSession 8 Where to
from Here?
Cooperative Extension Ag and Natural Resources
Farm and Risk Management Team
Last Update May 1, 2009
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Hedge, Buy Puts, or Do Nothing?It all Depends..
Date/Action Hedge Buy Puts Do Nothing
Feb 23 Sell Sep Class III _at_ 12.39. Expected September farm milk price is 13.54 Buy Sep 12.25 Put _at_ 0.55. Expected MINIMUM September milk price is 12.85 Take a nap.
Sep. 1 Class III 11.00 Milk Price Fut./Opt. Gain/Loss Comm. Net Milk Price 12.20 1.39 .05 13.54 12.20 .70 .05 12.85 12.20 0.00 0.00 12.20
Sep. 1 Class III 12.39 Milk Price Fut./Opt. Gain/Loss Comm. Net Milk Price 13.59 0.00 .05 13.54 13.59 - 0.55 .05 12.99 13.59 0.00 0.00 13.59
Sep. 1 Class III 14.00 Milk Price Fut./Opt. Gain/Loss Comm. Net Milk Price 15.20 - 1.61 .05 13.54 15.20 - 0.55 .05 14.60 15.20 0.00 0.00 15.20
Basis 1.20 Commission (futures or options)
0.05)
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Hedge, Buy Puts, or Do Nothing?It All Depends..

• If you know prices are going to fall relative to
  current levels, then hedging (sell futures
  contract) is the optimal choice even if the
  futures price doesnt meet your price goal
• If you know prices are going to rise, then do
  nothing
• If the odds are 50-50, then buying puts will
  provide down-side price protection but leave the
  opportunity for up-side gains. But remember that
  when you buy puts, there was always a better
  choice after the fact.

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Some very general guidelines

• If futures prices are relatively low, could go
  lower, but the probability is greater for prices
  to increase, buy a PUT option. (Premiums are
  usually low.)
• If futures prices are relatively high and the
  probability is greater that prices could decline,
  hedge with dairy futures contracts.
• If futures prices are below your price objective,
  but the probability is great that prices could go
  even lower, consider buying a PUT option.

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Some very general guidelines (Continued)

• If futures prices are at average levels and the
  direction that prices may take is unclear, the
  decision is equally unclear. Consider the size of
  premiums in making a decision to buy puts. There
  are some advanced strategies to consider as well.
• Cash forward contract decisions are similar to
  hedging in futures if a base price contract, or
  buying a PUT option if a floor price contract.

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Narrowing the Range

• What is the futures price in relation to your
  price targets?
• What are options premiums at strike prices in the
  vicinity of your basic price target?
• What is your price outlook and how confident are
  you with it? What does Bob Cropp have to say?
• Whats your banker have to say?

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BE SYSTEMATIC!

• Set aside management time on a regular basis to
  review prices and revise your price outlook
• Decide on critical levels - break points - for
  futures prices that will trigger specific
  actions.
• Write down your plan.

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Futures Price Check Points
Dream
Optimistic
Basic
Minimum
Absolute Minimum
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Use a Cheat Sheet
Current Month
Pricing Month
Futures price
Price Targets Abs. Min. Minimum Basic Optimistic Dream
Outlook for price - for price Net ACTION Hedge? How Much? Buy Puts? Forward Contract? Sit? Get more info?
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Organizational Issues

• Is there interest in continuing to meet as a
  marketing club to
• Hear presentations from outlook analysts,
  Exchange personnel, brokers, and other folks
  knowledgeable about futures
• Discuss market conditions and related hedging
  strategies
• Learn more about advanced strategies

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Organizational Issues (Continued)

• If we form a marketing club, whos going to take
  the lead?