Managing Volatility

Volatility, defined as the uncertainty about the range of prices, is the 800 pound gorilla that makes it difficult to know when to price your production. No matter how ominous it is, you have to learn to manage it.

Some would argue that they would prefer low volatility and stable prices. That would appear to be a recipe for putting market analysts and advisors out of work. If the price was known and stable, there would appear to be little need for any price risk management. Just produce, deliver, and collect your check.  But what if that known and stable price did not cover your cost of production? Be careful what you wish for.

First of all, low volatility does not translate directly to a stable or known price. Volatility is about the trading range. It is possible to have a very tight price range, but have the prices slip lower by small increments. Or on the other hand, the market could rally slowly over a long period of time with tight price range and small increments. Reducing volatility might reduce the confusion factor, but it does not solve the bigger problem of risk management. You still have to decide when to sell as long as the market is free to move up or down.

Time spent on wishing or hoping for lower volatility is wasted energy. Increased volatility is here to stay for many reasons — higher overall prices, commercial hedging, funds speculation, globalization, etc. The challenge is to figure out how you can harness the volatility and make it work for you. 

CZ12 MA(5,35)Let’s focus on the positive side and how you might be able to get volatility to work to your advantage. Take a look at the December 2012 corn chart (CZ12). There were six times when the market corrected down by more than 50 cents per bushel. Each of these was a potential opportunity to lock in price protection.  If you were willing to lift the protection at the bottom of each major correction, or put counter measures in place, the cumulative potential gain from hedging was $5.53.  Add that gain to the $7.6275 (less local basis) that you could have received in December, and you have more than a $13 crop.

We all know that it wasn’t possible to capture all $5.53 of the hedging potential, but don’t lose focus.  My initial goal for selective hedging was to capture 60 percent of each major move, which would have produced $3.31 or more of hedging profit and have made the crop worth just under $11.00.  Whether we could capture $1.00 or $5.00 is not the point. The point is that volatility is here, and it represents an opportunity. You can make it work for you if you are able to harness it with your price risk management.

As you evaluate the effectiveness of your 2012 marketing program, did you maximize price in the same way you maximized yield? Did you get near the $13 dollars that was possible, the $11 that was more realistic with selective hedging, the $7.985 that a simple moving average indicator would have gotten with one sale, or something less? USDA statistics will most likely show that a majority of the 2012 crop will be sold in the lower third of the price range, putting it below $6.25. Volatility created the opportunity to harvest an additional $400-$500 per acre. That is equivalent to an additional 50-75 bushels.

Looking forward, most analysts are projecting that we will approach trend yield, prices will slip back a bit, input prices will continue to rise, and margins will decrease.  Making volatility work for you is going to be even more critical in the future. .  You have to decide if it is worth the effort.

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Posted by Keith D. Rogers on 5 May 2013