The sky is simply not the limit when it comes to any market. Grain and oilseed prices climbed briskly through October and into November, thanks to the combination of lower-than-expected corn and soybean yields plus U.S. monetary policy. But the cure for high prices is definitely high prices. Demand is rationed and then the sell-off is on.
Volatile markets are a double-edged sword. Eventually, prices reach a point where demand is truly rationed or a new global event surprises market traders. China’s decision to cool food inflation this fall had immediate impact on North American grain prices.
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During periods of unstable world security or uneasy global financial markets — such as we may be facing as we head into 2011 — commodity markets quickly take on a different personality. But before we dig into how to market in volatile times, let’s take a quick look at this new beast.
There are four emotional drivers. The first is greed. Rising markets always have an element of greed fuelling their rise. Inevitably, the market becomes overbought. Greed then quickly changes to hope that prices will recover. But when that doesn’t happen, hope turns into fear that prices simply won’t recover. Then panic can pound market values to oversold levels. The sell-off is over.
One point always needs repeating. Rising bull markets typically don’t have a long life. Prices may soar, but as hope turns to fear, and fear turns to panic, the eventual drop is often steeper than the climb. This is a market characteristic that ag managers should always be aware of.
Bull markets burn out. Even so, however, overall grain bid ranges may trade at new and improved higher levels after the bullish price run has died off. It’s during these market rallies that best old-and new-crop pricing opportunities may be seen.
It’s also essential to know that a commodity market has four distinct stages in its lifespan. The first sees the market climb in steps. Prices move up, then rest, then move up again. This is a sure sign of a healthy price rise ahead. A bull market snorts, then rests, then snorts again.
The second stage is the final “blow off” rally. Futures spike up, sometimes for several trading sessions. Those caught on the wrong side of the market are in a squeeze. They rush to buy their way out of this market inferno. Trade volume and open interest rise. Buy orders from speculators force the market into a buying vacuum. It’s all buyers and simply no sellers.
The third stage is when the bull market begins to fail. The market stumbles. The rush of buy orders subsides. The number of open contracts or “open interest” suddenly drops. Commodity funds now exit their long positions. The sell-off begins. The market plummets virtually into a free fall.
And now for the fourth and final stage. The market drops so quickly that it actually gets oversold. We see a drop in the margin calls that force buyers to exit. Selling pressure eases, and prices actually rebound toward their true market value.
Sound crazy? It can be. But marketing your grain through volatile markets can be highly profitable for growers depending how you handle it.
Let’s say your grain is good quality and in good storage, and that local bids are rallying. Start by scaling in cash grain contracts. The key advantage of cash grain-company contracts is that growers aren’t exposed to margin call risk. Grain companies and crushers absorb this risk. But remember, you have to follow through on your delivery obligation. Failure to live up to your part of the bargain can create huge payout penalties. Try to limit that risk.
For new-crop grain, contract production only up to your comfort level. Prior to spring planting, that may be between 10 and 30 per cent of your expected 2011 production. Now you’ve profitably pre-priced as much grain as you’re comfortable with. But lets say the market flares even higher.
Now it’s time to scale in put options in a rising market. Put options are price insurance policies for a falling market. You pay a premium for this protection, but there is no delivery obligation or market call risk. And the best-case scenario is that put options or open market price insurance policies expire worthless. That would mean local bids remained high and profitable.
Another pricing alternative is to sell the futures outright as a short hedge. But this may be a dangerous strategy during the weather market season as it could increase the likelihood of margin calls. Be prepared for margin calls or else they may distort your best intended market plan. If you have a short (sell) futures position with a commodity broker, you may want to eventually convert it to a deferred delivery contract with a grain company once your production is better known. In other words, buy back your futures once you find an attractive deferred delivery contract (DDC) and your production is better known. This again shifts margin call risk away, but signing a DDC contract does commit you to delivery.
This marketing scenario changes if your new-crop production prospects are uncertain. In this situation, be less aggressive using cash contracts. Be more aggressive scaling in put options. In other words, temper your delivery obligation, but try to guard those profits while the price iron is hot. The worst market strategy for a grower is to do nothing. Never assume hot grain prices will hold. They won’t. And remember, bear markets unfortunately have a much longer lifespan than that of the bull.
If you understand markets, and if you have a plan in place, volatility can be exciting and profitable. It’s during these times that prices and growing profits can really excel.CG
Errol Anderson is author of the daily “ProMarket Wire” risk management report and a commodity broker located in Calgary. He can be reached at 403-275-5555 or by email at [email protected].
