Risk and Opportunity

We often like to think of risk and opportunity as being opposite sides of the same coin.

Thought about from the perspective of historical price ranges, one might say that at the 90th percentile, there is certainly opportunity for the market to increase in price moving forward in time, although the potential risk of declining prices is much greater at historically high price levels. If price has only been higher than current levels less than 10% of the time, but lower 90% of the time, the risk would therefore outweigh the opportunity. While not wanting to commit to a forward sale is certainly understandable given the opportunity for higher prices, a producer can still not overlook the risk of the price being lower. This is particularly true for an operation that has already realized their costs on the input side of the profit margin equation. A hog operation, dairy or cattle feedlot that produces their own feed or has committed to feed purchases in the local cash market is faced with the very real risk that declining prices may erode their future profitability. Similarly, a crop producer who has committed to all of their input costs for land, seed, fertilizer, fuel, etc. would likewise be at risk should the value of their crops decline over time.

So how would these operations approach this risk given they do not want to commit to a sale with the expectation of higher prices? One way to accomplish this would be to set a floor price to address the risk of lower prices. Buying a put option gives the holder the right without the corresponding obligation to sell at a certain price level for a cost. Often likened to an insurance contract, you essentially pay a premium to insure that your sale price will be no lower than the price level you have the right to sell at. This is referred to as the strike price of the put option. This insurance can be purchased in one of two ways. In the cash market, co-ops, creameries, elevators and packers may offer these types of minimum price contract alternatives for various forward time periods. A second alternative would be to use an exchange-traded derivative. Options can be purchased at the CME Group through a brokerage company for a variety of contracts including corn, soybeans, wheat, hogs, milk and cattle.

The common objection we hear in using this contracting alternative is the cost of the option. While it is true that the option has a cost, the corresponding benefit is the flexibility it provides in allowing for the opportunity to participate in higher prices. Thought of very simply, you can ask yourself whether or not you believe prices will rise by more than the cost of the option over the time remaining in the option’s life. If the answer is yes, then it may very well be superior to purchase a put option rather than locking in a fixed sale price in a forward time period. Just like buying insurance, the point of the contract is not so you can maximize its value by filing a claim. You wouldn’t want to face a situation where you have to file a claim when purchasing insurance and the same is true here. You would only exercise your right to sell at a pre-determined price level with a put option in the event the market has moved lower, which means your profitability is deteriorating in the open market.

Given that the option therefore will lose value if the market moves in your favor; i.e., crop, milk or livestock prices go up, how does one limit the cost of purchasing the option? There are a few ways this can be accomplished. First, going back to the insurance analogy, you can select the level at which you wish to purchase a floor. As an example, let’s assume that October Hogs are currently trading at $84.00/cwt. If you want to protect a floor at that level, the cost is about $4.00 for the right to sell at a price of $84.00/cwt. If however you were willing to take a lower floor, for example at $82.00/cwt., the cost would be $3.00 because the market would have to decline by $2.00 from current levels before that right becomes effective. This is similar to the concept of having a higher or lower deductible in an insurance contract, and the premium being more or less expensive, accordingly.

Another way to limit the cost of buying a put option to establish a floor at a certain price level is to accept a cap or ceiling at a higher level. This would involve selling an option to collect a premium in order to limit the cost of the option you are purchasing. You pay a premium for the right to sell at a certain price, and similarly, you can receive a premium for taking on the obligation to sell at a different price. Continuing with the previous example, if October Hogs are trading at $84.00/cwt., you may want to place a floor at that level, yet you are not willing to commit to a sale price there. You may however be willing to sell at a higher price, for instance at $92.00/cwt. You would receive a premium for taking on the obligation to sell at $92.00/cwt., and this will help to offset part of the cost of purchasing the right to sell at $84.00/cwt.

Commonly referred to as a collar, window, or fence, this essentially is a minimum/maximum price combination and again may be accomplished either in your local cash market or through exchange-traded derivatives. Why would someone consider doing this? Maybe they feel that while there is risk below $84.00 for their hogs, the perceived opportunity to participate in higher prices may also not be much greater than $92.00/cwt. This could very well be the case if $84.00 is already a very high historical price for October Hogs while the $92.00 level would represent an even higher percentile of the historical price range. At this level, the potential opportunity for October Hogs to trade much higher might be considered very limited.

Further ways to reduce cost might involve setting a limited range of protection to lower prices. Instead of having an unlimited floor for example at $84.00/cwt. in October Hogs which effectively would protect the producer to all lower price levels, they may choose to limit their protection below a certain threshold. Perhaps for instance the producer perceives at the same time the opportunity to participate in higher prices might be small above $92.00 in the October Hogs example, the risk below the market may likewise be limited below a certain threshold. Due to either fundamental considerations or other factors that are perceived to support the market at lower price levels, a hog producer might consider ending their protection under $76.00/cwt. for instance. In this example, the producer establishes a range of protection between $84.00 and $76.00. Instead of having unlimited protection below $84.00 for a cost of $4.00 which effectively places a floor on October Hogs at $80.00/cwt., this range of protection between $84.00 and $76.00 might cost $3.00 for example.

This might be akin to an insurance contract paying out a maximum benefit in the case of a total loss. The premium will be lower if the insurance company knows up front the maximum potential settlement cost of a potential claim. For the example just reviewed, the maximum benefit to the hog producer would be a total of $8.00/cwt. should hog prices decline below $76.00 for a net cost of $3.00/cwt. If the producer is comfortable having only limited protection to lower prices because they perceive limited risk below $76.00/cwt., they may be willing to do this in exchange for the lower cost.

In protecting either a profit margin as a whole, or individual pieces of the margin, it is important to weigh the perceived risks and opportunities that exist. The greater the perceived risk, the more inclination there would be to secure a profit margin or lock into a fixed price level. The greater the perceived opportunity, the more one would be inclined to allow for flexibility to improve the profit margin or price level being managed. By thinking of risk and opportunity in these terms, more informed contracting decisions can be made to help protect forward profitability.