Hedging 

The below is written specifically for Agricultural products, please know that these strategies can also be applied for any exchange traded products, i.e. Interest rates, oil, foreign investment/ currencies.

Common Sense Capital Farmer Hedging Strategies:

1) Only about one out of every ten years produces a weather rally which actually does considerable damage to crops, therefore use the weather spikes in price to establish price protection into harvest.

2) When long the cash market take advantage of a tight basis.

3) In most crop years Mother Nature will present three separate weather scares. Use these runs in price to hedge about 25% of your crop per weather scare.

4) Options can be a very valuable tool for hedging purposes. We ask that all farmers know the cost of production of their grains and in turn determine at what price you are financially compensated by marketing your crop.

5) Remember that a producer is always long so avoid the temptation to also buy the futures and options to become double long the board. This can be a very dangerous and have disastrous effects to your hedge program.

6) Call option selling is a very powerful tool that a farmer holds in his arsenal. When we take into account high volatility and time value, good option premium can be gathered at the right times which only puts more money into your pocket.

Producer hedging involves selling Chicago futures contracts as a temporary substitute for selling corn in the local cash market. Hedging is a temporary substitute, since the corn stocks will eventually be sold in the cash market. Hedging is defined as taking equal but opposite positions in the cash and futures market. For example, assume a producer who has harvested 10,000 bushels of corn and placed it in storage in a grain bin. By selling 10,000 bushels of corn futures the producer is in a hedged position. In this example, the producer is long (owns) 10,000 bushels of cash corn and short (sold) 10,000 bushels of futures corn.

Selling the futures in a hedge leaves the local basis unpriced. Thus, the final value of the corn is still subject to fluctuations in local basis. However, basis risk is much less than cash price risk. By selling futures, the producer has eliminated the financial loss, which would occur on the cash grain from a futures price decline.

The hedge position is removed or lifted when the producer is ready to sell the corn in the cash market. It is lifted in a simultaneous two-step process. The producer sells 10,000 bushels of corn to the local grain elevator and immediately buys back the futures position. The purchase of futures offsets the original short (sold) position in futures, and selling the cash grain converts the position to the cash market. Hedging illustration

Hedging involves taking opposite but equal positions in the cash and futures markets. If you own 10,000 bushels of corn as discussed above, you are long cash corn. If you sell 10,000 bushels of corn on the futures market you are short corn futures.

If the price increases as shown in Figure 2, the value of the cash corn increases. However, the futures contract incurs a loss because you sold (short) corn futures and now have to buy corn futures at the higher price to close out the futures position. If both the cash and futures prices increase by the same amount, the increase in the value of the corn will exactly offset the loss in the futures market. The net price received from the hedge is exactly the same as the cash price when the hedged was initiated (not including trading cost, interest on margin money, or storage costs).

If the price decreases as shown in Figure 3, the value of the cash corn decreases in value. However, the futures contract results in a gain because you sold (short) corn futures and now can buy corn futures back at a lower price to close out the futures position. If both the cash and futures price decrease by the same amount, the decrease in the value of the corn will exactly offset the gain in the futures market. The net price received from the hedge is exactly the same as the cash price when the hedge was initiated (not including trading cost, interest on margin money, and storage costs.)

The difference between the cash price and the futures price is the basis. The basis in the illustrations in Figure 2 and 3 is the same when the hedge is lifted as when it was initially placed. However, if the basis is smaller when the hedge is lifted as shown in Figure 4, the gain in the cash market will be greater than the loss in the futures market and the net price received from the hedge will be slightly larger. The outcome is the same if prices decline (Figure 5). The loss in value of the cash grain will be less than the gain in the futures market resulting in a higher net price. Basis usually narrows from harvest into the winter, spring and summer; resulting in a higher price. However, a higher price is needed due to the cost of storing grain past harvest.

Hedging can also be used to establish a price for a crop before harvest. Assume the hedge is placed before harvest but lifted at harvest. The net price (not including trading cost or interest on margin money) is the futures price at the time the hedge is placed, less the expected harvest basis. If prices are higher at harvest, the higher cash price is offset by the futures loss. If prices are lower, the futures gain is added to the lower cash price. Whether the basis narrows and by how much is not known until the hedge is lifted. Although hedgers can lock in the futures price when they hedge, they are vulnerable to basis changes.

Mechanics of placing a hedge

Once hedging principles are understood, a key step in the hedging process is selecting the right commodity broker. A producer should expect the broker to accurately and quickly execute orders and serve as a source of market information. Most brokerage firms have weekly market reports as well as periodic in-depth research reports on the corn market outlook, which may be useful in formulating a marketing strategy. Also, a commodity brokerage firm that is familiar with local cash market opportunities has some distinct advantages.

It is extremely important that a broker understand how hedging and price risk management fit into the producer's production and marketing program. The producer and the broker must realize that hedging is a tool to reduce price risk. However, producers sometime use futures markets to speculate on price changes and thus are exposed to increased price risk. Generally, speculation and hedging should be done in two separate accounts. Inexperienced hedgers should seek a broker willing to help them increase their understanding of market mechanics.

After selecting a broker, formulating a marketing plan, and opening a hedge account, the producer is ready to place trading orders. The broker can supply information on the types of orders to place. Once the broker receives the order, it will be phone or wired to the floor of the commodity exchange. The order is relayed to a pit broker who will execute it in the trading pit, provided it is within the current market range. A confirmation of the executed order is then phoned or wired back to the local broker. Many brokerage firms can execute the order while the client waits on the phone for the confirmation price.

Margin account

To maintain a position in the futures market, producers must deposit margin money with the brokerage firm. Initial margin requirements provide financial security to insure performance on the futures commitment. If the producer sells a contract in the futures market and the futures price subsequently rises, this represents a loss of equity in the futures position. These higher prices may require additional margin money and may thus result in a margin call. The producer must then supply these additional funds to maintain the hedge position. If the futures price moves down, the producer who is short (sold) futures will have futures profits credited to his/her account. The producer can call for this excess margin to be paid to him/her. In the futures market the margin position is updated each day.

Margin calls should not be viewed as a loss but rather as part of the cost of insuring against a major price decline. In a hedged position, losses on futures contracts are offset by the increasing value of the physical grain inventory.

Although margin calls should not be viewed as a loss, they complicate a producer's cash flow. If prices rise, the futures loss must be paid (additional margin) as the loss accrues. However, the additional value of the grain is not realized until the grain is sold when the hedge is lifted. So, a cash flow problem occurs.

Once the position is closed out, the producer is no longer required to maintain a margin account (for that transaction). Thus the producer can receive his margin deposits, plus (minus) futures profits (losses), less brokerage fees.

Common Sense Capital wants to make you, the farmer successful in marketing your grain and livestock products. Through in depth research and a committed marketing plan we strive to make you as profitable a producer as you can be. For more information please contact us.