Have you ever sold a house?
Even if you haven’t, imagine you’re selling your home today. The market has been good and you think you could easily get the price you’ve been targeting.
That is…if you could list your house today.
Unfortunately, you’re unable to list your house for 6 more months due to other life circumstances.
It’s been a seller’s market in your area for a while now, and it seems that might come to an end soon. If you wait 6 months, you risk the market cooling off and prices falling, quickly shifting to a buyer’s market and becoming less likely you’ll get your target price.
Wouldn’t it be nice to lock in the price today at the market rate to transfer your house 6 months from now?
Now, imagine you’re not a home owner with a house to sell 6 months from now.
Instead, you’re a farmer with corn to sell a few months from now.
In this scenario, you should be glad you’re a farmer and not a home owner selling a house.
Why?
Well, farmers can actually lock in the price for their commodities that they will deliver in the future.
How is this possible?
Farmers have a few options to lock in the price for their commodities. One of the ways they do this is through hedging with futures.
What is hedging with futures?
Answer: Hedging is all about minimizing price risk and protecting a price. Hedging involves taking a position in the futures market, as well as selling and delivering the physical grain to your local buyer.
Hedging is NOT:
Taking a bet
Trying to outguess the market
A risky position
If you’re scared of the futures market because you’ve heard of people losing lots of money, those people were not hedging.
Rather, they were SPECULATING.
“What is speculating?”
Answer: Speculating is taking a position in the futures market with the intention of profiting on a market move or price change you ‘expect’ will happen.
Speculating is NOT:
A hedge position
A strategy for minimizing risk
A safe position
The futures market is not something to be afraid of if you’re using it to hedge and protect price. It can, however, be risky if you’re using it to speculate.
So, HOW do you hedge grain using futures?
First, remember that as a farmer, you’re a SELLER of the commodity you’re raising.
Thus, in the futures market when you’re hedging, you will also be a seller.
Your goal in hedging is to protect the price you receive for selling your grain.
Let’s be sure to clarify where you deliver your grain, even if you’re using the futures market to hedge:
You will still deliver your grain in the CASH market to your local grain buyer.
Hedging simply allows you to use the futures market to protect a price before you create a cash contract.
Recall that futures is a key component in the calculation of cash price:
Cash Price = Futures Price + Basis
Once you decide to sell your grain in the cash market to your local buyer, you will exit your futures position, which is referred to as “offsetting.”
As a farmer selling your crop, you’re a SELLER in the cash market and SELLER in the futures market.
Just like any transaction, there’s a buyer and a seller.
Thus, to offset and exit the sold futures position, you will have to take the opposite position and BUY back the sold futures contracts.
Depending on how the market has moved while you’ve held the futures poition, you’ll experience either a gain or a loss in futures.
Phew! Take a quick breath and lets digest all of that information using the following two examples.
Example using a FALLING futures price:
If the price of Dec corn is $4.53 (CZ19) in June, and that price is profitable for your operation, you may decide you want to protect the price for a portion of your corn that will be delivered at harvest.
(Remember, this is a FUTURES price. No basis has been included so cash price is not established. For more info on what basis is, CLICK HERE.)
However, you’re not sure which grain buyer you want to sell your cash corn to yet. You’d rather maintain the flexibility to compare and find basis opportunities, or wait and see which buyer has a shorter line when it comes time to haul.
You’re also worried about selling too much cash grain in case you don’t raise a crop–you’d rather be in a more liquid position than locked in a contract to deliver with a grain buyer in the cash market.
While you will eventually have to sell and haul your grain to a local cash buyer, hedging is the mechanism that allows you to reduce price risk before selling in the cash market.
Imagine it’s June 15th and these are today’s prices:
Futures price is $4.53 (CZ19)
Cash price at your local grain elevator is $4.13 per bushel.
For flexibility, you decide to HEDGE 10,000 bushels by selling futures contracts instead of selling cash grain.
You SELL 2 FUTURES contracts of CZ19 futures at $4.53 per bushel
(i.e. each corn futures contract = 5,000 bushels)
Fast forward to September 15th, 2019:
CZ19 corn has fallen to $4.22 per bushel (a decrease of $-0.31 from June).
Cash price is $3.82.
*We’re going to assume that basis stayed the same for sake of the example.*
You might be asking yourself the following question: “If cash price fell, how did hedging help me protect price? Now I have to sell cash grain at a lower level.”
If you decide to sell cash today and offset your hedge position (i.e. buy back the position you had sold), let’s take a look at the net selling price you’ll earn on the 10,000 bushels you hedged:
| Original Position (SOLD Futures) | (CZ19) at $4.53 |
| Offset Position (BOUGHT Futures) | (CZ19) at $4.22 |
| GAIN/LOSS on Futures | + $0.31 |
| CASH Sale on 9/15 | $3.82 |
| Net Selling Price (per bushel) | ($3.82 + $0.31) = $4.13 |
*Remember, futures trades are made through a licensed broker and are subject to margins and fees. Fees vary by broker and are not included in this example.
Key to hedging: You must OFFSET the hedge at the SAME TIME you SELL CASH in order to protect price.
Notice that this net selling price is the SAME as the cash price of $4.13 that was posted the day you sold futures because the loss in the cash price was offset by the gain in the futures hedge.
Now you might now be thinking…the hedge seems like a good idea if prices fall, but what if futures rally after I take a hedge position?
In a scenario of a rising futures price, the hedge still protects price. While there will be a loss on the futures position, cash will be sold at a higher price. Thus, the original price from June remains protected.
Example using a RISING futures price:
Imagine it’s June 15th and these are today’s prices:
Futures price is $4.53 (CZ19)
Cash price at your local grain elevator is $4.13 per bushel.
Fast forward to September 15th, 2019:
CZ19 corn has rallied to $4.84 per bushel.
Cash price is $4.44
*We’re going to assume that basis stayed the same for sake of the example.*
| Original Position (SOLD Futures) | (CZ19) at $4.53 |
| Offset Position (BOUGHT Futures) | (CZ19) at $4.84 |
| GAIN/LOSS on Futures | – $0.31 |
| CASH Sale on 9/15 | $4.44 |
| Net Selling Price (per bushel) | ($4.44 – $0.31) = $4.13 |
*Remember, futures trades are made through a licensed broker and are subject to margins and fees. Fees vary by broker and are not included in this example.
Sure, you could have elected not to hedge and waited to sell grain in hopes the price would rally. But no one knows what will happen to the market price in the future. What if the price would have fallen instead, like it did in our first example?
The key to hedging is that you remain true to the goal.
The goal is not to speculate.
Rather, the goal is to lock-in profitable prices and reduce the price risk on a portion of your production, while still giving you the flexibility to wait to determine your delivery location, delivery time frame, and the location you’d like to sell cash grain to.
If you have any other questions about hedging, please let me know! If you work with a marketing advisor, always be sure to communicate your goals and comfort level with futures when determining a marketing plan together.