Last month I explored the hedging practices of merchandisers, exporters and processors, and how it is more than avoiding risk. These are basis traders who employ the purest form of hedging - placing long and short hedges regardless of price expectations or market opinion.
I should add one more point: These players overwhelmingly choose futures, not options, as their hedging tool of choice. When standard operating procedure calls for the hedging of every purchase and sale, you naturally choose the lowest cost and most effective form of risk management.
This month I turn my attention to hedging with an opinion. In “New Concepts Concerning Futures Markets and Prices,” the great Holbrook Working (a professor of economics at Stanford University and a legend in the futures industry) described selective and anticipatory hedging. These forms of hedging share a common bond. The decision to hedge is guided by price expectations.
As defined by Working, selective hedging is to hedge or not hedge stocks depending upon your price expectations. Did you have a bin full of unpriced soybeans and a stomach full of worries before the March plantings report? Did you sell July futures or buy May put option just in case it was a bearish report? Working would call that a selective hedge. Likewise for the oil refiner who sells crude oil futures or the jeweler who sells gold futures because they’re concerned about the value of their inventory.
Anticipatory hedging is also guided by price expectations, but it is not matched by an equivalent stock of goods. Consider, for example, the plight of cookie makers. They are commodity buyers who worry about small crops and bullish reports. They can manage their worries with the purchase of wheat, sugar and soybean oil futures to cover input costs. Working would call these anticipatory hedges. Likewise the pre-harvest sale of December futures to lock-in a price for new crop corn (no stocks on hand – just anticipated stocks).
Anticipatory hedging dominates the livestock and dairy industries. No “standard operating procedure” here – hedges are placed with an opinion. One opinion might say. “This cattle market is poised to crash.” Another opinion says “Selling milk futures will lock-in a profit.” Either way, the order to sell is guided by price expectations.
There is one more important form of hedging that Working did not explore: cross-hedging. How can you manage price risk in barley or sunflowers, where there is no futures contract for the cash commodity? You can cross-hedge using different but closely related futures contracts like corn or soybeans. Cross hedging is another form of selective or anticipatory hedging, where the hedging decision is guided by expectations.
Anticipatory hedgers are more open to the use of options. When hedging is selective and guided by expectations (or fears), the use of tools with more flexibility is appealing. And nothing says market opinion better than a 2-for-1 call ratio back spread.
Spring is here and the planters are rolling. Are you a micro view bull who sees good demand, small stocks and potential droughts? Or are you a macro view bear, who wonders how commodity prices can rise while the world economy falters? If you’re not following a marketing plan, your opinion will determine your use (or lack of use) of selective or anticipatory hedges. I hope your market opinion is right.
Holbrook Working explained why hedging is more than long or short, and more than avoiding risk. That’s an enduring achievement for an article published 50 years ago.