Risk Management Strategies Offered by Elevator Operators

While some agricultural producers do not engage in any type of grain hedging or marketing strategy - they simply sell their crop in the cash market upon harvest and accept the prevailing price - many producers utilize grain 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 grain hedging strategies yourself using commodity futures and options? Why not simply continue to rely on the local elevator operators?

The Advantages of Constructing A Grain 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. CME Group 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 grain hedge in the corresponding CME Group futures and options market. So by establishing the grain hedge yourself directly in the futures and options market, you're simply cutting out the middle man.

Grain Hedging Strategies with CME Group Futures and Options

The wide variety of CME Group 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 grain 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 CME Group futures and options. These are among the simplest of grain hedging strategies. Please see, Hedging with CME Group Futures & Options at right for a more complete list of hedging strategies including the innovative zero-cost collar or range hedge. Most of these grain 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 CME Group 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 grain 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 grain 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 grain 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 grain 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 grain hedge using CME Group 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 CME Group 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.