What is in this article?:
The true hedge
Many growers know they should consider hedging to manage risk, but fear of using futures often turns them off.
Iowa State University (ISU) Extension economics answers questions about the mysteries of futures and options. They include the basics of a true hedge – that of selling a commodity futures contract to lock in a floor price that hopefully spells profit.
Hedginginvolves selling futures contracts as a temporary substitute for selling in the local cash market, says Chad Hart, ISU Extension grain marketing specialist. ISU defines hedging as taking equal but opposite positions in the cash and futures markets.
For example, assume a farmer has harvested 10,000 bu. of corn and stored it. He hedges by selling 10,000 bu. of corn futures (two 5,000-bu. contracts). The producer is long, or owns 10,000 bu. of cash corn and short, or has sold 10,000 bu. of futures, corn.
Since the grower has sold futures, price has been established on the major component of the local cash price. Selling futures has eliminated the financial loss, which would occur on the cash grain from a futures price decline.
If the futures price is $6.50/bu., for example, and the cash price is $5 when the corn is sold, the hedge position is removed or lifted at the same time the grower sells the corn in the cash market.
The grower sells 10,000 bu. of corn to the local elevator or other buyer. He then buys back the futures position, which is probably below the $5 cash price, due to the basis.The purchase of futures offsets the original short (sold) position in futures, and selling the cash grain converts the position to the cash market.
ISU points out that selling futures in a hedge leaves the local basis (the difference between futures and cash) unpriced. The final value of the corn is still subject to fluctuations in local basis.
Basis may be wider during harvest, when the grain pipeline is full. It may narrow leading up to harvest when demand surpasses supply.
Margin calls can hit growers if the futures price increases. However, ISU says the margin call shouldn’t be viewed as a loss, but rather as part of the cost of insuring against a major price decline. In a producer-hedged position, losses on futures contracts are offset by the increasing value of the physical grain inventory.
“The margin call issue weighs heavily on a lot of people,” Hart says. “When you hedge, there is uncertainty what the cost will be, and you never know when it will be.”
So when futures prices are set, growers should consider buying call options to compensate for the increase in futures, he says. Call it a hedge against a true hedge.