Market Price Risk Hedging using Futures and Options
Farmers face various risks impacting crop profitability. These risks include weather, pests, market price fluctuations, input costs, and regulatory changes. To manage these risks and safeguard profitability, farmers can employ strategies such as diversification, crop insurance, and hedging with futures and options.
This article covers hedging risks with market price volatility using Futures and Options contracts. Futures contracts help farmers lock in a price for their crops, providing certainty and mitigating price fluctuations. Using options provides flexibility in hedging against market price risks.
Let us explore a few practical use-cases for a farmer in the midwest growing corn.
Here is a calendar for planting and harvesting various crops in the US as per USDA:
Market Price Risks
Price Volatility: Fluctuations in corn prices due to factors like global demand, weather conditions, trade policies, and market speculations can impact the profitability of your crop.
Supply and Demand Dynamics: Changes in supply and demand fundamentals can influence market prices and your selling price at harvest.
Hedging Market Price Risk with Futures
Farmers can use the futures market to hedge market price risk by entering into futures contracts that lock in a price for their crops at a future date. This hedging strategy helps farmers mitigate the uncertainty of price fluctuations and secure a predetermined price for their produce, thus protecting their revenue.
The Chicago Board of Trade (CBOT) offers futures contracts for corn, soybeans, and wheat.
Opening a Futures Position
Farmers can sell futures contracts (take a short position) to lock in a future selling price for their crops.
Calculate Hedge Ratio
Determine the appropriate hedge ratio, which is the ratio of the number of futures contracts needed to hedge the price risk of the actual crop being produced.
Monitoring and Adjusting the Hedge
Continuously monitor market conditions and the performance of the hedge. Adjust the hedge as needed by rolling over contracts, closing positions, or taking new positions based on changing market dynamics.
Setting Stop-Loss Orders
Consider setting stop-loss orders to limit potential losses in case the market moves against your position beyond a certain threshold.
Closing Out Positions
Close out the futures positions by offsetting the initial trade before the contract expires or by physically delivering the crop if required.
Benefits of Hedging with Futures Contracts
- Price Protection: Lock in a predetermined selling price to protect against adverse price movements in the market.
- Revenue Certainty: Ensure revenue certainty by hedging price risk and stabilizing income from crop sales.
- Risk Management: Mitigate price volatility risk and financial uncertainty associated with fluctuating market prices.
- Financial Planning: Facilitate better financial planning and budgeting by knowing the expected revenue from crop sales.
Use Case — Price Hedging using Futures Contracts
Let’s walk through a real example of how a farmer can use futures contracts to lock in a price for corn:
Farmer anticipates to harvest 180,000 bushels from 1000 acres.
Hedge Ratio Calculation: Based on the expected yield, and a Corn Futures contract represents 5000 bushels of Corn, the farmer calculates the number of contracts to be 36 (180,000 / 5,000).
Opening Futures Position: The farmer decides to sell 36 futures contracts for corn on the Chicago Board of Trade (CBOT) to hedge against price risk.
Contract Details: Farmer chooses Sep 2024 expiring contracts, which are trading at 451 cents/bushel.
Margin: Margin for 36 contracts (36 * $1300 = $46800.00)
Commission: Execution cost for 36 contracts (36 * $1.00 = $36.00)
Current Spot Price: 440 cents/bushel
Come Sept:
Harvest & Sale: Upon harvesting the corn, the farmer sells the physical corn at the prevailing market price.
Futures Settlement: At the expiration of the futures contracts, the farmer settles the futures positions, offsetting the initial trade and realizing the price locked in through the futures market.
Outcome — Market price declines: If market prices decline below the locked-in futures price of $4.51 per bushel, the farmer benefits from the higher selling price secured through the futures contracts, thus mitigating potential revenue losses.
Sep 2024 Corn at expiry: 440 cents/bushel
Profit from hedge: Per bushel we gain 451cents — 440cents = 11cents. For a total gain of 180,000 * 11 = 1,980,000 / 100 = $19,800
Minus Commission: Execution cost for 36 contracts (36 * $1.00 = $36.00)
Margin will be returned to your account.
Outcome — Market price increases: If market prices rise above the locked-in futures price, the farmer may miss out on potential higher selling prices for the physical corn but still benefits from price certainty and risk management.
Sep 2024 Corn at expiry: 460 cents/bushel
Missed-Profit from lock-in: Per bushel we miss 460cents — 451cents = 9cents. For a total missed profit of 180,000 * 9 = 1,620,000 / 100 = $16,200
Minus Commission: Execution cost for 36 contracts (36 * $1.00 = $36.00)
Margin will be returned to your account.
Hedging Market Price Risk with Options
Farmers can also use Options to hedge market price risk. Here is an example of an options hedge using a combination of selling a call option and buying a put option:
Options Hedge Strategy for a Seller of Corn:
Sell Call Option (Covered Call)
- Objective: Generate income from selling the call option premium.
- Action: Sell a call option contract for the amount of corn you plan to sell in the future.
- Strike Price: Choose a strike price above the current market price of corn.
- Expiration Date: Select an expiration date that aligns with your selling timeline.
Buy Put Option
- Objective: Protect against a potential drop in corn prices.
- Action: Buy a put option contract as insurance against a price decline.
- Strike Price: Select a strike price below the current market price of corn.
- Expiration Date: Choose an expiration date that covers your selling period.
Scenario Analysis:
If Corn Prices Increase:
- The call option sold will limit your upside potential but allow you to sell corn at the agreed-upon strike price.
- The put option bought will expire worthless as you are not exercising the right to sell at a lower price.
If Corn Prices Decrease:
- The put option bought provides protection by allowing you to sell corn at the higher strike price, mitigating losses from the price decline.
- The call option sold remains in place, generating income from the premium received.
Use Case — Hedging using Options
As a seller of corn, the farmer may want to protect from the risk of price fluctuations in the corn market. One common strategy to hedge against such risks is using options.
Hedge using a PUT option:
Buy Put Option: Protect against a potential drop in corn prices. Buy a PUT option contract as insurance against a price decline. Select a strike price below the current market price of corn (or at market price). Choose Sep 2024 expiry.
Current Market Price for Sep 2024 Corn Futures Contract: 451 cents/bushel
Current Market Price for Sep 2024 Expiry Put Options at Strike 440 cents/bushel: 21.5 cents
Total premium paid for 36 option contracts: 21.5 * 36 * 5000 = $38,700.00
If Corn Prices Increase
The put option bought will expire worthless as you are not exercising the right to sell at a lower price.
If Corn Prices Decrease
The put option bought provides protection by allowing you to sell corn at the higher strike price, mitigating losses from the price decline.
Use Case — Income from Options
Here is an example of an options income generating CALL option:
Sell a Call Option: Generate income from selling the call option premium. Sell 36 Corn Options Contracts, for Sep 2024 expiry, on Corn Sep 2024 expiring Corn Futures. The current premium for a strike price of 460 cents/bushel is 24.5 cents/bushel.
Current Market Price for Sep 2024 Corn Futures Contract: 451 cents/bushel
Current Market Price for Sep 2024 Expiry Call Options for 460 c/bushel: 24.5 cents
Total Income from sale of 36 options contracts: 24.5 * 36 * 5000 = $44,100.00
Margin required for 36 contracts: 36 * 1150 = $41,400
If Corn Prices Increase
The call option sold will limit your upside potential but allow you to sell corn at the agreed-upon strike price.
If Corn Prices Decrease
The call option sold remains in place, generating income from the premium received.
Understand Basis
Generally, cash market and futures markets will move in the same direction but not necessarily to the same extent. The farmer would benefit if the difference between the cash price and the futures price approaches zero. Basis is simply the difference between local cash prices and the futures price at the CME. Basis is influenced by several factors:
- Transportation
- Profit Margins
- Storage Costs
- Local supply and Demand
In the above example, the Corn price in the Spot market is 440 c/bushel, while the price in the Futures market is 451 c/bushel. This puts the basis at 11c/bushel.
Building a Fence
Building a fence by using options is an alternative that can be considered. By building a fence around your expected price, you set a minimum price under which the price cannot fall and a maximum price over which the price cannot rise. To build a fence you buy a PUT option with a strike price just below the current future price and sell (write) a CALL option with a strike price above the current futures price. The put option establishes a floor price for your grain. The call option establishes a ceiling price.
The cost of the fence is the put option premium plus option trading costs. There may also be interest on margin money for the call option if price rises. However a portion of this cost is offset by the premium you receive from writing the call option.
Here is a chart of Corn Futures prices over the last 1 year:
The Sep 2024 Corn Futures price is 4.51c/bushel. The strike prices and option premiums are:
Based on the last years futures price, if we assume the Sep 2024 Futures contract to be around 4.90c/bushel, by selling a $4.90 strike CALL option, we will receive 15.4c/bushel in premium. Buying a PUT option at 4.40c/bushel, we pay 22.5c/bushel in premium. The net premium cost is 15.4–22.5 = -7.1 c/bushel.
Fence: Minimum Selling Price from downward movement
The minimum selling price from the fence is the strike price of the put option, less the net premium cost, less the options trading costs, less the basis.
In the above example, the minimum price from the fence is the 440c/b PUT strike price, plus the 15.4c/b CALL premium, less the 22.5c/b PUT premium, minus 5c/b for trading costs, minus a 10c/b basis, or 417.9c/bushel.
Assume Sep 2024 Corn futures price drops to 410c/bushel at harvest and the actual basis is 8c/bushel. You exercise the PUT option which places you in the futures market at 440c/bushel. You buy back that position at 410c/bushel for a 30c/bushel futures gain. At the same time, you sell your CASH corn for 402c/bushel. Add the 30c/bushel futures gain, and the 15.4c/bushel CALL premium to the 402c/bushel cash price. Then subtract the 22.5c/bushel PUT premium and the 5c/bushel trading cost. The net price is 419.9c/bushel. The net price is 17.9c/bushel higher than expected price (402c/bushel) because the basis is 8c/bushel.
Fence: Maximum Selling Price from upward movement
The maximum selling price from the fence is the strike price of the call, less the put premium, plus the call premium, less option trading costs, less the basis.
Assume at harvest Sep 2024 Corn futures price is 505c/bushel. Cash corn rise to 500c/bushel. The actual basis is 5c/bushel. The 490c/bushel strike price CALL option that you sold may be exercised by the call option buyer. If so, you have to sell the buyer Sep 2024 futures for 490c/bushel and buy back the position for 505c/bushel for a 15c/bushel loss.
After adjustments, the net price is 472.9c/bushel, which is 5c/bushel more than the expected selling price.
Conclusion
Implementing futures and options strategies can help farmers mitigate risks, secure revenue, and manage uncertainties in the volatile agricultural markets. By leveraging these financial tools, farmers can enhance their financial stability and make informed decisions to protect their crop investments effectively.
