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Chuck the crystal ball — protect your downside

If you’re worried about missing big rallies and don’t like delivery commitments, 
then consider options, says David Derwin

David Derwin has one piece of advice for farmers wondering where markets will go in 2017: “Expect the unexpected.”

“A lot of the marketing advice out there is about trying to guess where the market is going to go, and I think too much time is spent there,” said Derwin, an investment adviser with PI Financial, a Winnipeg investment and commodity futures firm.

“I don’t want to guess too much on where the markets are going. It’s better to have a good strategy in place and know what you’re going to do whether prices go up, down, or sideways.”

And the strategy that Derwin favours is using exchange traded options.

“The best way to look at options is kind of like insurance. You pay a premium and get your downside protected,” said Derwin.

“You buy insurance on your equipment, your buildings, and your crops, and if your shed burns down, your insurance covers that. An option basically provides that price protection, so that if prices go down, the value of that option essentially increases to offset the loss on your cash prices.”

Options are very flexible, said Derwin, because they give producers the opportunity — not the obligation — to sell their crop at a certain price or before a certain date.

“You can buy them and sell them at any time, and you’re not locking in a price,” he said.

“So often, the hesitancy to hedge or look at other marketing tools is the fact that you don’t want to lock in a price. We’ve seen it so many times — you put in your target price, your target price gets hit, and the first couple of days you’re happy your target price got hit. And then three weeks later, the price is 40 or 50 cents a bushel higher and you say, ‘Darn, I wish my target price hadn’t got hit.’

“With options, there is an element of being able to protect your downside but still have your upside.”

And unlike hedging, there are no production commitments with options, Derwin added.

“That’s another reason why there’s hesitancy to hedge — you don’t want to commit and then have to deliver your grain that isn’t going to come out of the ground for six to nine months and you don’t know what you have,” he said.

“Options give you the ability to protect the downside and not have to worry about not having the crop to deliver.”

Once those marketing strategies are in place, market forecasts can act as a road map for producers, said Derwin.

Downward drift

The cattle markets have had “some pretty big moves” over the past year, but the trend has been mostly one way.

“Cattle is one example where, over the past couple of years, prices seemed to go relentlessly higher and higher and higher,” said Derwin. “And then, through 2016, cattle prices were basically drifting sideways to lower. That was pretty much the pervasive trend.

“Right now, we’re still under that same kind of longer-term bigger-picture trend. The longer-term trends on cattle have definitely been drifting lower and heading down.”

Fat cattle prices have seen a fairly big range in the past year.

“From their peak down to the trough, we’ve had about a move down of about 20 per cent,” said Derwin. “Late in the year, cattle prices had a nice strong move higher, and in many cases, we ended the year not much different from where we began. So we want to be taking advantage of prices when they’re higher and not get too panicky when we have some big moves lower.”

It’s the same story with feeder cattle, though feeder cattle prices haven’t rebounded as high. “From top to bottom, they’ve had about a 20 per cent price move, and they’re still down about 12 per cent for the year.”

Going into 2017, producers will want to “capture those highs and avoid those lows,” said Derwin.

“It can’t be done all the time, but the whole point of managing revenue exposure is to smooth out some of those extreme moves as well,” he said.

“The trends are drifting sideways or lower, and are likely to continue, so we want to be thinking about doing some hedging.”

Seize the day

In the canola market, producers saw about a 20 per cent change in prices over the course of 2016.

“For canola, we got to highs of about $520 a tonne, and they were sitting there during some low points at about $450 a tonne,” said Derwin.

“There were two times that canola got to $520 or $530 a tonne, and when you look back over the past three or four years, that’s been pretty much the high end of the range for canola.”

When canola hits those high prices, it’s “prudent” to take advantage, he said.

“We know that, after a market has had a good strong move, it should cause us to act a little bit.”

New crop is setting at “some decent levels,” and that’s where producers could see rallies in 2017.

“Canola has been very much sideways, especially for this new crop. It’s really been in a range between about $480 to $520 a tonne for the past year. I would expect to see some fairly big moves within that range,” said Derwin.

“It’s not unusual to see grain prices have a range of 15 to 20 per cent in any given six-month period. It wouldn’t surprise me for a bit of a price move to occur.

“But what we want to do if and when it gets there is be ready to act and protect those prices.”

Wheat may surprise

Where things could get a little more interesting in 2017 is in the wheat market, said Derwin.

“Wheat could be the one that surprises us a little bit,” he said.

“If we get a 10 per cent increase in wheat futures, we might want to be a little more proactive in using options to protect that gain we see.”

Except for some blips in the late spring and early summer, wheat prices went “pretty much straight down” in 2016.

“If we’re looking at the futures markets, we’ve seen the price of wheat drop between 15 to 20 per cent in the last year,” said Derwin.

“For those who were a little more attentive, there were some nice little price moves higher in the spring and the summer that would have allowed you to capture prices at a higher level.”

Those little rallies show that “you never really know where prices could go,” said Derwin, and that’s one of the benefits of using options in a marketing plan.

“It allows you to put in place that floor price when you have that downside. Because you’re not locking anything in, if prices have gone higher, you can still capture that upside.”

So instead of relying on guesswork when marketing this year, producers should be using marketing strategies such as options to manage whatever the markets throw at them.

“Spend more time and effort understanding the strategies and learning how they work and what to do when prices get to different levels, as opposed to trying to guess or predict or hope that prices get to those different levels.”

About the author

Reporter

Jennifer Blair is a Red Deer-based reporter with a post-secondary education in professional writing and nearly 10 years of experience in corporate communications, policy development, and journalism. She's spent half of her career telling stories about an industry she loves for an audience she admires--the farmers who work every day to build a better agriculture industry in Alberta.

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