Commodity trading hedging strategy




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Commodity trading hedging strategyDouble Hedging

Catastrophe Futures

BREAKING DOWN 'Hedge'

Hedging is analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding – to hedge it, in other words – by taking out flood insurance. There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn't free. In the case of the flood insurance policy, the monthly payments add up, and if the flood never comes, the policy holder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their head.

A perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the hedge is 100% inversely correlated to the vulnerable asset. This is more an ideal than a reality on the ground, and even the hypothetical perfect hedge is not without cost. Basis risk refers to the risk that an asset and a hedge will not move in opposite directions as expected; "basis" refers to the discrepancy.

Hedging Through Derivatives

Derivatives are securities that move in terms of one or more underlying assets ; they include options. swaps. futures and forward contracts. The underlying assets can be stocks, bonds. commodities. currencies. indices or interest rates. Derivatives can be effective hedges against their underlying assets, since the relationship between the two is more or less clearly defined.

For example, if Morty buys 100 shares of Stock plc (STOCK) at $10 per share, he might hedge his investment by taking out a $5 American put option with a strike price of $8 expiring in one year. This option gives Morty the right to sell 100 shares of STOCK for $8 any time in the next year. If a year later STOCK is trading at $12, Morty will not exercise the option and will be out $5; he's unlikely to fret, however, since his unrealized gain is $200 ($195 including the price of the put). If STOCK is trading at $0, on the other hand, Morty will exercise the option and sell his shares for $8, for a loss of $200 ($205). Without the option, he stood to lose his entire investment.

The effectiveness of a derivative hedge is expressed in terms of delta. sometimes called the "hedge ratio." Delta is the amount the price of a derivative moves per $1.00 movement in the price of the underlying asset.

Hedging Through Diversification

Using derivatives to hedge an investment enables for precise calculations of risk, but requires a measure of sophistication and often quite a bit of capital. Derivatives are not the only way to hedge, however. Strategically diversifying a portfolio to reduce certain risks can also be considered a—rather crude—hedge. For example, Rachel might invest in a luxury goods company with rising margins. She might worry, though, that a recession could wipe out the market for conspicuous consumption. One way to combat that would be to buy tobacco stocks or utilities, which tend to weather recessions well and pay hefty dividends .

This strategy has its tradeoffs: if wages are high and jobs are plentiful, the luxury goods maker might thrive, but few investors would be attracted to boring counter-cyclical stocks, which might fall as capital flows to more exciting places. It also has its risks: there is no guarantee that the luxury goods stock and the hedge will move in opposite directions. They could both drop due to one catastrophic event, as happened during the financial crisis. or for unrelated reasons: floods in China drive tobacco prices up, while a strike in Mexico does the same to silver.

Managing Commodity Price Risk Using Hedging and Options

Table of Contents

Introduction

This Factsheet provides an overview of commonly-used price risk management tools as well as concise and easily understandable definitions of terms used by those providing risk management advice.

Purpose of Futures Markets

Futures markets are price discovery and risk management institutions. In futures markets, the competing expectations of traders interact to discover prices. In so doing, they reflect a broad range of information that exists on upcoming market conditions. Futures markets are actually designed as vehicles for establishing future prices and managing risk so you can avoid gambling if you want.

For example, a wheat producer who plants a crop is, in effect, betting that the price of wheat won't drop so low that he would have been better not to have planted the crop at all. This bet is inherent to the farming business, but the farmer may prefer not to make it. The farmer can hedge this bet by selling a wheat futures contract .

Futures contracts are sometimes confused with forward contracts . While similar, they are not at all the same.

Forward Contracts

A forward contract is an agreement between two parties (such as a wheat farmer and a cereal manufacturer) in which the seller (the farmer) agrees to deliver to the buyer (cereal manufacturer) a specified quantity and quality of wheat at a specified future date at an agreed-upon price. It is a privately negotiated contract that is not conducted in an organized marketplace or exchange.

Both parties to a forward contract expect to make or receive delivery of the commodity on the agreed-upon date. It is difficult to get out of a forward contract unless the other party agrees.

All forward contracts specify quantity, quality and delivery periods. If any of these conditions are not met, the farmer will usually have to financially compensate the buyer. It is essential you understand your legal obligations before entering into a forward contract in case you cannot meet the conditions of the contract.

Futures Contracts

Futures contracts, while similar to forward contracts, have certain features that make them more useful for risk management. These include being able to extinguish contract obligations through offsetting . rather than actual delivery of the commodity. In fact, very few futures contracts are ever delivered upon.

Futures contracts are traded on organized exchanges in a variety of commodities (including grains, livestock, bonds and currencies). They are traded by open outcry where traders and brokers shout bids and offers from a trading pit at designated times and places. This allows producers, users and processors to establish prices before commodities are traded. Futures prices are forecasts that can and do change according to a variety of reasons, such as crop or weather reports.

There are basically two types of traders: hedgers and speculators.

Hedgers are people who produce, process or use commodities and want to reduce their price risk or establish prices for commodities they will trade in the future.

Speculators are people who attempt to profit through buying and selling, based on price changes, and have no economic interest in the underlying commodity.

Futures contracts have standardized terms established by the exchange. These include the volume of the commodity, delivery months, delivery location and accepted qualities and grades. The contract specifications differ, depending on the commodity in question.

This standardization makes it possible for large numbers of participants to trade the same commodity, which also makes the contract more useful for hedging.

Trading Gains and Losses

It helps to study speculation first - trading futures without an interest in the underlying commodity - in order to understand hedging.

September corn is trading at $3.50/bu, but you believe the price will be lower than this in September. You might take a short position (sell futures), and if the price falls, profit from offsetting with a long position (buying back futures):

Grain Price Hedging Basics

File A2-60

Updated July, 2015

The business of a crop producer is to raise and market grain at a profitable price. As with any business, some years provide favorable profits and some years do not. Profit uncertainty for crop producers arises from both variance in the cost of production per bushel (especially from yield variability) and uncertainty of crop prices.

Many techniques are used by producers to reduce risk from production loss. These may include adequate size of machinery, rotating crops, diversification of enterprises, planting several different hybrids, crop insurance, and many others.

Crop producers also have marketing techniques which can reduce the financial risk from changing prices. Rising prices generally are financially beneficial to producers and falling prices are generally harmful. However, it is never known with certainty whether prices will rise or fall. Futures hedging can help establish price either before or after harvest. By establishing a price, the producer protects against price declines, but also generally eliminates any potential gain if prices rise. Thus, through hedging with futures, producers can greatly reduce the financial impact of changing prices.

How Prices are Established

Prices of corn and soybeans are established in two separate but related markets. The futures market trades contracts for future delivery. These future contracts are traded at a commodity exchange and are for a specific time (contract delivery month), place (primarily Chicago, Illinois), grade (#2 yellow shelled corn), and quantity (1,000 or 5,000 bushel contract sizes). The cash market is where the physical grain is handled by firms such as country elevators, processors, and terminals.

The term basis refers to the price difference between the local cash price and the futures price. The basis is different at alternative marketing locations. Thus, for effective marketing, it is important to be aware of the local basis at country elevators, as well as at nearby processors or terminals.

Local cash prices thus reflect two components: the futures price and the local basis. Figure 1 helps illustrate this point. As an example, a local cash bid of $2.50 per bushel for corn may be derived from a futures price of $2.70 and a local basis of 20 cents. It is helpful to think of local cash prices in terms of the futures component and the basis component when examining marketing alternatives.

The Hedging Concept

Producer hedging involves selling corn futures contracts as a temporary substitute for selling corn in the local cash market. Hedging is a temporary substitute, since the corn 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.

Since the producer has sold futures, price has been established on the major component of the local cash price. This can be seen in Figure 1, which illustrates that the futures component is the most substantial portion of the local cash price.

Selling 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 (variation) is much less than futures price risk (variation). 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.

Producer Hedging Illustrations

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 also 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 hedge 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 also decreases. 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. 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.

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.

Processor Hedging Illustrations

If you are a grain processor or livestock producer needing grain for processing or feed, hedging can be used to protect against rising grain prices. Once again hedging involves taking opposite but equal positions in the cash and futures markets. But in this case, you dont have grain that you plan to sell but rather plan to buy grain at a future time period to fill your processing or feed needs. Instead of selling futures at the time of placing the hedge, you buy futures. So you own grain (futures) in the futures market but are short grain in the cash market (will need grain but dont own any).

If grain prices rise as shown in Figure 6, you make money in the futures market because you purchased futures and can now sell them at a higher price. However, the grain for processing or feed needs now cost more. So the gain in the futures market offsets the increase in the grain purchase price.

If grain prices drop as shown in Figure 7, the futures you purchased at the beginning of the period must now be sold at a lower price. However, the grain for your processing or feed needs now cost less. So the loss in the futures market offsets the decrease in the grain purchase price.

If the difference between the cash and futures prices remains the same over the hedging period, the loss in one market will exactly offset the gain in the other market (not considering transaction and interest costs).

Mechanics of Placing a Hedge

Once hedging principles are understood, a key decision in the hedging process is selecting the right commodity broker. A producer or processor 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 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 marketing program of the producer or processor. The producer (processor), and the broker must realize that hedging is a tool to reduce price risk. However, producers (processors) sometimes use futures markets to speculate on price changes and thus are exposed to increase 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 phoned 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.

To maintain a position in the futures market, producers (processors) must deposit margin money with the brokerage firm. Initial margin requirements provide financial security to insure performance on the futures commitment. If the producer (processor) sells (buys) a contract in the futures market and the futures price subsequently rises (declines), this represents a loss of equity in the futures position. These higher (lower) prices may require additional funds to maintain the hedge position. If the futures price moves down (up); the producer (processor) who sold (bought) futures will have futures profits credited to his/her account. The producer (processor) 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 (increase). In a producer hedged position, losses on futures contracts are offset by the increasing value of the physical grain inventory. In a processor (livestock producer) hedged position, losses on futures contracts are offset by lower priced cash grain purchases.

Although margin calls should not be viewed as a loss, they complicate a producers 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. For grain processors and livestock producers, falling grain prices can result in margin calls before the benefits of lower priced cash grain purchases are realized. So, a cash flow problem may occur.

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

Robert Wisner, retired economist. Questions?

Don Hofstrand. retired extension value added agriculture specialist