Imagine this, you’re a jeweler selling an engagement ring.
Yes, I did just come up with this analogy after looking down at my engagement ring. Stay with me, it gets more creative.
A fine young man walks into your store and says he needs to purchase a ring. He has one hesitation about buying it today though–he’s worried diamond prices will fall and he’ll miss out on the opportunity to buy it cheaper later.
However, he thinks gold is going to rise.
Well, lucky for him, you’re a really flexible, custom jeweler and agree to let him buy the gold that will be used to make the ring, but allow him to wait up to 3 months to buy the diamond.
There’s one catch: he must buy the diamond from you, even if the price doesn’t fall.
He’s satisfied with that and tells you, “If that diamond reaches $2,500, lock in my price.”
Deal.
He’s happy he has time to potentially pay a lower price (fingers crossed) and you’re happy you just sold an engagement ring!
Now, how does this engagement ring purchase relate to you having a contract for corn with your local buyer?
Have you ever utilized a Basis or HTA (futures only) contract?
The great thing about either of these contracts is that you are only setting one component of your cash price at a time.
In the case of an HTA (futures only) contract, you set your futures price and leave basis open to set later.
In the case of a Basis contract, you set basis and leave the futures price open to set later.
Remember:
Cash Price = Futures + Basis
With either an HTA or Basis contract, you can execute the same pricing strategy that the man buying the engagement ring used in our example.
You can set the price of one component (futures or basis) and put in a target price for the other component.
How nice is that?!
Let’s look at an example similar to the ring analogy.
Basis levels have been strong in many areas of the country recently.
Because of that, let’s say you make a Basis contract for corn today to take advantage of the strong basis and give yourself time to price futures.
Your contract:
Quantity: 10,000 bushels
Delivery: 12/1/19 – 12/31/19
Basis: -0.05
Futures month: CH20 (March 2020)
Let’s revisit the cash price calculation for this contract:
Cash Price (?) = Futures CH20 (?) + Basis (-0.05)
For most grain buyers, you’ll need to price any contract off the CH20 by the end of February.
Thus, you have from today (12/9/19) until the end of February (date depends on the buyer) to set your futures price.
Great, right?!
Wellll, only if you make this contract with a target futures price in mind…
Today, CH20 is trading at $3.75.
If my goal is $4.00 futures for a cash price of $3.95 ($4.00 + -0.05), then I darn well better put that futures pricing goal somewhere other than my mind if I expect to execute on it.
Why?
Because let me tell you what normally happens.
$4.00 sounds great now, and we know we can make money at that price, but then $4.00 comes around and we think, “Wow, if it goes to $4.50 maybe I can buy a new pickup!”
So you don’t set futures on your basis contract at $4.00.
And then $4.00 futures turns into $3.50 and it’s the end of February and you wind up with a cash price of $3.45.
Don’t think about the pickup. 🙂
Instead, think like the engagement ring guy with your price in mind and have the confidence to say, “Grain buyer, please put in a pricing order for this basis contract. If CH20 gets to $x.xx, I want to price futures.”
The other great thing about pricing orders is that they’ll execute automatically, which means they can execute in the overnight trading session when you’re sleeping…
…or during the day when you’re working on something else and can’t watch the market every second.
Believe me, go into any Basis or HTA contract with a pricing goal and the confidence to put an order to automatically price at that level if the market gets there.
I don’t think you’ll be disappointed you placed the target pricing order, or at least we never have been on our farm. 🙂
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