Do I Need a Hedge Account?

Heather Moffit, Grain Risk Management Advisor, Agricultural Marketing First

The Chicago Board of Trade was created in 1848 when a need for a central marketplace for agricultural products was realized. Since that time the CBOT has continued to expand and offer other products. As early as 1877 more formalized trading was introduced and speculators entered the scene. The CBOT is still the primary grain exchange, although speculative trading makes up the majority of contracts traded. What does the exchange do for the farmer? It creates a constant bid and offer system to allow us to buy and sell grain at any time we wish (liquidity), now and in the future.

Farmers are able to use exchange traded agricultural commodities to "hedge" the risk of pricing crops. To successfully use futures or options on futures contracts you need a certain amount of knowledge to understand how these work. There are a variety of misconceptions surrounding options and futures trading. There is always the story of the "guy" who lost his farm trading in the futures market. First, the "guy" who lost his farm trading futures was speculating. He was not hedging the product he produced. A hedger is someone who takes a position using futures or options to protect price until an offsetting cash transaction can be made. This is done ONLY on the amount of grain that he has or will produce. Hedgers are actual producers or buyers/sellers (industry) of the specified commodity. Speculators are those who buy grain futures with no other motive than to profit from the position. It is not wise for farmers to speculate in agricultural commodities. Farming has enough risks without adding another.

Another misconception surrounds option contracts. The statement, "I hear 80% of all options expire worthless," is often quoted. In order to use an option hedge strategy you have to understand options. Ask yourself some questions. If you buy a call option after selling your grain why are you buying it? You want to maintain upside potential over a specified period of time. You are willing to pay some money for this ownership (option premium). What happens if the option expires worthless? Probably the market remained flat, therefore prices didn't rally, and you were better off selling your grain when you did rather than hanging on and paying carry charges. If the market rallies and your option gains in value do you have a management strategy? Owning grain post harvest has a cost. Even if you store your crop in your own bins, the cost of carry must be calculated.

A hedge account can allow you to continue to own grain on paper post harvest, but most importantly it also allows you to lock in prices prior to harvest. In times of production uncertainty, the market rallies, giving producers pricing advantages. These prices are often taken advantage of...but minimally. Not knowing your own production stops aggressiveness. We often sell "a little", later wishing we'd sold a lot more. When the market rallies, sell some crop and increase coverage by buying puts. When you buy a call or put option your only expense is the premium paid. Buying the put would create a price floor while you wait to calculate your harvest bushels.

When the grain markets rally, great prices are offered nearby and in the deferred contract months. As well, looking a year or more ahead, prices can often look attractive. Elevators will often book those prices for you. If you can't find a buyer, an alternative would be to sell a futures contract. Expect margin requirements with this position. If you are shorting futures at the top end of a commodities price range, you are locking in an excellent price for your crop. Pick a price and be happy with your choice.

Using options on futures contracts can create opportunity and flexibility within your marketing program. Before you use these strategies, take a course or work with someone who can offer guidance and management suggestions. Not using options because statistically most expire worthless is not a good excuse for not incorporating them in your risk management toolbox. Be proactive! When you create a diversified marketing program with built-in flexibility, you have an edge when marketing your products.