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Why price risk management is more important than price prediction

With grain marketing you can’t simply expect upside price swings and disrespect downside risk.

As a farmer you are tasked with pricing your commodity amid an ever changing set of circumstances. 2020 has certainly provided plenty of fluctuating events.

Just as the past months have contained some unexpected developments, more surprises—bearish and bullish— will inevitably surface before the next crop is marketed. That means it’s even more important to understand and define price risk management in your business.

Risk Management requires your constant vigilance. It means planning for the next unknown. History has taught it is easy for a change in fortune to catch us off guard.

Relying on a philosophy of expecting upside and not respecting downside is dangerous. One can easily look at recent history as a reminder of expenses exceeding revenues. That’s why we defend the balance sheet through managing price risk.

Don’t get caught

We know that price will always change. It is easy to get caught thinking prices must rally (crop damage, drought areas, China needs food! etc.) Unfortunately, prices do not “have” to go higher.

Stories will report that prices are going higher and stories will report that prices are going lower. The truth is no one has any idea what the market is going to do. 

Time and resources are spent seeking someone to reveal market direction. Low price and low volatility years generate producer interest in having someone else do the marketing. 

The truth is, commodity price is in an ever-changing equilibrium influenced by events far too numerous to quantify. The demand for this elusive information is what leads to an ever-changing supply of grain contracts and “experts” to administer them, to help the farmer market their crop.

There’s one caveat

Selecting the best contract is only revealed with hindsight. The success of a marketing strategy is based on market direction, as some contracts work best in higher markets, other contracts work best in lower markets.

With the success of contracts/strategies based ultimately on price direction, experience teaches those that attempt to predict prices that it cannot be done consistently. 

So, what is price risk management? First, it recognizes this difficulty and removes the focus from predicting specific incidents and redirects the focus to how you can defend prices against any possible occurrence.

Price risk management is NOT price prediction. It is “optionalized” margin management for those who have price risk. 

This approach turns price volatility into a welcome event. 

Your task is to plan for all opportunities and make sure market changes do not inflict harm to your balance sheet. Plan for positive price outcomes, but do not leave yourself at risk for negative outcomes.

Marketing and helping farmers with marketing advice is a difficult business. Producers desire information that will determine price direction and inevitably those that try to predict price will be grossly wrong some years. 

The take-away? 

Do not have a bias about where prices will go - the market has a way of punishing the price predictor. Simply manage the price risk, protect the downside, and keep flexibility to the upside. Have a consistent, non-emotional, and disciplined plan for higher or lower markets.

If you are not currently using price risk management tools, now is the time to educate yourself. Sit down with an adviser or find a risk-management consultant with whom you are comfortable.

Contact Advance Trading at (800) 664-2321 or go to www.advance-trading.com
Information provided may include opinions of the author and is subject to the following disclosures:
The risk of trading futures and options can be substantial. All information, publications, and material used and distributed by Advance Trading Inc. shall be construed as a solicitation. ATI does not maintain an independent research department as defined in CFTC Regulation 1.71. Information obtained from third-party sources is believed to be reliable, but its accuracy is not guaranteed by Advance Trading Inc. Past performance is not necessarily indicative of future results.
The opinions of the author are not necessarily those of Farm Futures or Farm Progress.
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