Managing Risk When Margins are Low – or Negative

You may think that the goal of margin management is to capture and protect favorable profit margins. And you would be right – but only to a point.

While agriculture producers can indeed use various contracting strategies to take advantage of attractive available margin opportunities, the benefits of managing margin risk don’t end when those margins are low – or even negative. By allowing you to maintain the precise balance between protection and opportunity that is right for your operation, practicing margin management can help you lower your risk at any margin level.

Find the Right Balance for Your Operation
Risk and opportunity are opposite sides of the same coin or strategy. If you stay completely open in the market, you retain 100% of the opportunity for improved profitability, but also have zero protection from losses. At the other extreme, you can establish 100% protection by locking in input costs and revenue, but the tradeoff is that you would not participate in any potential favorable price movements. In between is an range of possibilities. For example, you might want to cap your exposure at 75% of any market losses, which means you would participate in 25% of any improved profitability. The right risk/opportunity balance for your operation will depend on several factors, including your competitive advantage, level of debt, cash flow and other balance sheet considerations as well as your tolerance for risk.

Take a Holistic View of Risk
As a producer, you face risks from both the cost and revenue sides of the margin equation. That’s why you need to take a comprehensive approach that takes into account your entire portfolio of positions. Looking at the “delta” of each position gives you valuable insight into the risk of each, as well as your total net exposure. Delta refers to the sensitivity of an option price to a change in the price of the underlying futures contract. Expressed in percentage terms, delta values range from zero to negative or positive 100. When the underlying futures price rises, the price of an option with a delta of +100% will climb in lockstep, while the price of an option with a delta of +50% will rise by half that amount and an option with a delta of -50% would fall by half.

You can use delta to identify your needs for coverage on both the input cost and revenue side of the margin equation. For example, after purchasing feeder cattle, a cattle feedlot has exposure to input costs for the corn and other feed needed to finish the cattle. It also has exposure on the revenue side, on the value of fat cattle that will be sold to a beef packer. Assuming the feedlot has not yet purchased feed or entered into a sales agreement, the simple price risk profile is shown below:

Initial Position Position Delta Net Exposure
Corn Short – Need to purchase -100% -100%
Cattle Long – Need to sell 100% 100%

At this point, the feedlot may be facing negative margins – the price paid for the feeder cattle plus anticipated cost of corn may be greater than the current futures price for finished cattle. The feedlot might prefer not to lock in these losses, but they need to purchase corn to get the cattle started. Depending on the current costs of feed, they may consider purchasing as much as half of their total corn needs on the cash market. This step immediately cuts their input cost exposure by 50%. To cover the remaining half, they might purchase at-the-money call options against December corn futures. These call options, with a delta of +50%, further reduce their exposure by 25% (50% coverage x 50% delta). These positions and the resulting effect on net exposure are shown below.

Portfolio Position % Corn Needs Position Delta Net Exposure
Initial position: Short corn All (100%) -100% -100%
Buy cash corn Half (50%) 50% -50%
Buy at-the-money calls (50% delta) Half (50%) 25% -25%

To address the revenue side of the equation, the feedlot may purchase at-the-money put options, which carry a delta of -50%, against all of their exposed cattle. In this way, they effectively cut their revenue risk exposure in half, as shown below:

Portfolio Position % Cattle Inventory Position Delta Net Exposure
Initial position: Long cattle All (100%) 100% 100%
Buy at-the-money puts (50% delta) All (100%) -50% 50%

As prices change over time, the feedlot can make adjustments to capture gains and maintain a comfortable risk/opportunity balance. For example, if corn prices drop, the feedlot can further reduce their net input exposure by replacing their call options with additional purchases on the cash market. If cattle prices rise in early fall, they may lock in the sale price by selling cattle futures contracts. By replacing the put options with fixed sales, the feedlot increases delta on the positions and further reduces their revenue exposure.

Account for Time and Opportunity
Rather than guess at what the market will do or simply hope that margins will improve, you should aim to maintain a net exposure that matches your risk/opportunity profile as it changes over time. When you have a long time to manage a specific risk, the balance of your margin portfolio should tilt toward the opportunity side. As margin opportunities arise and time grows shorter, you should adjust your portfolio to account for the change in your risk tolerance. In the end, the right margin management strategy will aim to maintain the balance between limiting risk and leveraging opportunity that matches your current exposure – regardless of margin levels.

If you have questions or would like help creating a margin management plan for your operation, please contact CIH at 1.866.299.9333.