Did you know that the chief economic justification for the creation of a regulated commodities futures and options market is
to enable producers to hedge the price risk that arises from their normal business operations? For agricultural producers
who are naturally long corn, wheat, oats or soybeans, Chicago Board of Trade (CBOT®) futures and options enable the construction
of hedging strategies that reduce the uncertainty of the price received from grain sales. These futures and options can be used to replicate many of the heding
strategies offered by your local elevator operator and, more importantly, can be used to create other strategies that are more
responsive to your expectations and budget. This Learning Center will show you how.
Risk Management Strategies Offered by Elevator Operators
While some agricultural producers do not engage in any type of hedging or marketing strategy - they
simply sell their crop in the cash market upon harvest and accept the prevailing price - many producers utilize hedging strategies made available
by their local grain operators. The more popular of these strategies include the forward contract, the hedge-to-arrive (HTA) contract,
and the minimum price contract. So why bother to construct hedging strategies yourself using commodity futures and options? Why not
simply continue to rely on the local elevator operators?
The Advantages of Constructing A Hedge Yourself
There is, of course, the old adage, 'If you want something done right, do it yourself.' There is no substitute for the satisfaction
and sense of control that comes from knowing exactly what is going on. That is, knowing how the hedge works, knowing
what you have to gain or lose, and knowing what to watch out for, if anything. The latter, in particular, is really
the best way to avoid a financial nightmare down the road. And such a financial nightmare was realized by
corn producers across several states in the summer of 1996 who relied on HTA contracts to hedge and who didn't fully understand the
implications of the contract.*
Beyond this, you may have other reasons to reduce your dependency on the local elevator. Perhaps you feel that their fees are too high, or that the
terms of their contracts are too restrictive. Maybe you find disputes too hard to reconcile. Or it could be that you want to
diversify business exposure and not conduct all of your business with the same counterparty. CBOT futures and options
eliminate this counterparty credit risk because every transaction is backed by the financial guarantee of the clearing corporation.
When you hedge using a strategy provided by the elevator operators, they in turn often establish an offsetting hedge in the
corresponding CBOT futures and options market. So by establishing the hedge yourself directly in the futures and options market,
you're simply cutting out the middle man.
Hedging Strategies with CBOT Futures and Options
The wide variety of CBOT futures and options provides the producer with a multitude of choices, much more so than with the
local elevator. Using futures, options or combinations thereof, the producer can construct a hedge that best conforms to
his or her price expectations and operating budget. For example, the HTA contract and minimum price contract can both
be replicated using CBOT futures and options. These are among the simplest of hedging strategies. Please see,
Hedging with CBOT Futures & Options at right for a more complete list of hedging strategies including the
innovative zero-cost collar or range hedge. Most of these hedging strategies can be further customized, for example, by varying the strike
price or expiration of the component options in attempt to improve the overall performance of the hedge, all of which
is again made possible because of the extensive listings of CBOT contracts that are available for trading.
A chief concern and in some cases, limiting factor, when using futures and options is the operating cash that is needed while the hedge is active.
In general, the outright selling of a futures
contract or an option contract generates a margin requirement which must be covered by cash in the account.
The premium of a purchased option must be paid for in full upfront.
And cash is required to cover the day-to-day loss, if any, on the hedge position. For producers, the latter becomes an issue
during periods of rising prices. While the premium of purchased options
is a cost, the others are not: the act of closing the hedge position eliminates the margin requirement and the capital loss, if any, on the
hedge position itself should be recouped upon selling grain in the cash market at a higher-than-expected price.
Because of its importance, notional cash requirements are listed for each of the hedge strategies described at right. Some require less
operating cash than others. In particular, the hedge strategy, "Zero-Cost Collar with Upside", is not capital intensive yet
still provides a floor selling price while leaving open the upside.
Constructing your own hedge using CBOT futures and options is at first a learning process. Think of the time spent as an investment
in your business. The agricultural futures and options contracts that trade on the CBOT have been around for a very long time and will continue to be around.
Once you learn these hedging techniques, you can use them for years to come, and so can your children and their children.
Managing the Futures & Option Hedge
A hedge is not put in place and then forgotten. Rather, it is dynamic. It must be managed to properly respond to changing price expectations.
For example, the size of the hedge may need to be reduced or increased, or some or all of the hedge may need to be rolled to another
contract month. The on-going management of a hedge using CBOT futures and options is much easier than that with the local elevator for the
following reasons:
(1) Information. The free dissemination
of prices by the CBOT enables calculation of the value of a futures and options hedge on an almost real-time basis.
(2) Accessibility. With regular trading in the pit and overnight electronic trading, CBOT contracts can be bought and sold quickly and easily
almost any time of the day, allowing the producer to instantly react to a changing market environment.
(3) Variety. The many futures and options contracts that are available for trading not only permits a variety of hedges to be constructed, but
also enables flexibility in managing those hedges.
For a description of some management strategies that can be used by the agricultural producer, please see, Managing the Futures & Option Hedge,
above and at right.