Part Two:  A User’s Perspective

The goal of hedging is to transfer price risk from one party to another.  You may remember this from the initial article I wrote on hedging.  This article will focus on how users of a product can roughly lock in a price to transfer risk to another party.  If you would like to learn more about how a producer can roughly lock in a price, read my previous article here:  Hedging with Commodity Futures:  It’s All About Managing Price Risk!

Why should I hedge?

This is the question you will have to ask yourself when trying to figure out the benefits of hedging.  As a user, would you like to be able to roughly determine the price you will have to pay for a commodity in the future? The futures markets can help you do this.

Cash – Futures = Basis!

This is a very important formula to remember.  Basis is the difference between the cash price and the futures price of a commodity.  Basis consists of carrying charges and costs of transportation for the commodity to an exchange approved delivery point.  For example, if the cash corn market is at $6.93 and the futures price is $7.00, the basis would be -.07 (6.93-7.00).  As the delivery month draws near and the prices converge, basis approaches zero.

There are two types of hedges, long hedges and short hedges.  This article focuses on long hedges.  Someone who is buying the commodity later in the cash market is a long hedger.  A long hedger is someone who wants to protect themselves from price increases (user).  A long hedge is also known as being “Short the basis.” A hedger who is short the basis (long hedger) benefits from the basis becoming more negative.  In the corn example above, if it was a long hedger, he would want the basis to get more negative.

To sum it up, a long hedger wants to protect against increasing prices and benefits when basis weakens.

Real-World Example

A feed company will need to buy 25,000 bushels of corn on December 1st.  Due to rising per capita incomes around the world, the feed company believes that increased demand for feed grain and food could result in an increase in corn prices.  The company decides to place a long hedge on March 23rd to protect themselves from rising prices.  December corn futures are currently trading at $6.15/bu and the December cash market is currently at $5.83/bu.  Each corn futures contract contains 5,000 bushels.  The feed company buys five corn futures contracts at $6.15/bu.  The feed company’s goal is to lock in a price of roughly $5.83/bu for corn.

It is now November 30th and the feed company’s concern that corn prices would rise held true.  Corn futures are currently at $7.58/bu and December cash corn is at $7.46/bu.  The company exits its futures positions and buys the cash grain.  See the table below for the sum of the transactions.

Change in Basis

The feed company lost $1.63 on the cash side and gained $1.43 on the futures side.  The net result of the hedge is a loss of 20 cents per bushel.

The net price paid for the corn is calculated by subtracting the change in futures to the cash price at which the grain was sold.

-OR-

Basis strengthened during the hedge, causing the feed company to pay more than they had hoped.  Remember that the goal of hedging is to transfer price risk and set the price you would like to pay in a roughly determinable range.  Had the feed company not hedged, they would have been stuck paying $7.46/bu of corn!  This is quite a large difference from the $6.03 they actually paid.

Add Hedging To Your Plan

Hedging is a great risk management tool.  Yes, the corn prices in the example could have decreased and the feed company would have lost money in futures, but they would have paid less for the cash grain.  If that was the case, a producer could have benefitted by placing a short hedge!  Remember, the goal of hedging is to transfer price risk and set the prices one will receive or pay within a roughly determinable range.  Reducing exposure to market surprises allows users and producers to plan their operations more confidently.

This post originally appeared in FutureSource’s Fast Break Newsletter on February 25, 2011, where Drew Wilkins is a regular contributor on various futures trading topics.

The goal of hedging is to transfer price risk from one party to another.  Hedging has been used for hundreds of years to help producers and buyers protect themselves from price risk.  By hedging, producers and users can set the prices they will receive or pay within a roughly determinable range.  However, hedging is still an underutilized tool that many choose not to use.  This article will help you to understand the benefits of using the futures markets to reduce price risk.

Why should I hedge?

That is the question you will have to ask yourself when trying to figure out the benefits of hedging.  Would you like to protect your crops against a decline in value?  As a buyer, do you want to insulate yourself from a significant rise in prices?  The futures markets can be used to hedge the risk in both of these situations.

Cash – Futures = Basis!

This is a very important formula to remember.  Basis is the difference between the cash price and the futures price of a commodity.  Basis consists of carrying charges and costs of transportation for the commodity to an exchange approved delivery point.  For example, if the cash corn market is at $6.93 and the futures price is $7.00, the basis would be -.07 (6.93-7.00).  As the delivery month draws near and the prices converge, basis approaches zero.

Long Hedges vs.  Short Hedges

There are two types of hedges, long hedges and short hedges.  Someone who is buying the commodity later in the cash market would be a long hedger.  Someone who is selling the commodity later in the cash market would be a short hedger.  A long hedger is someone who wants to protect themselves from price increases (user).  A short hedger is someone who wants to protect themselves against declining prices (producer).  A long hedge is also known as being “short the basis” and a short hedge is known as being “long the basis.” A hedger who is short the basis (long hedger) benefits from the basis becoming more negative.  A hedger who is long the basis (short hedger) benefits from the basis becoming more positive.  In the corn example above, a long hedger would want the basis to get more negative.  A short hedger would want the basis to get more positive.

To sum it up, a long hedger wants to protect against increasing prices and benefits when basis weakens.  A short hedger wants to protect against decreasing prices and benefits when basis strengthens.

Real-World Example

A farmer who has been on the fence about hedging decides to hedge his corn crop.  He thinks that prices will remain around the current level or decrease in late August when he anticipates selling his new crop.  The cash price for new crop corn is $5.52 and the September futures price is $6.28.  The farmer anticipates that he will have 10,000 bushels of corn to sell.  Since the farmer wants to protect himself against a decrease in prices, he will be a short hedger.  His goal is to lock in the price of $5.52/bu for corn.  Each corn futures contract contains 5,000 bushels.  The farmer sells two September 2011 corn futures contracts at $6.28 on 2/23/11.

It is now September and the farmer’s instincts held true.  Cash corn prices are currently at $5.00 and September futures are trading at $5.25.  The farmer sells his grain in the cash market and offsets his position in the futures market on 8/28/11.

Change in Basis

The farmer lost -.52 on the cash side, but his short futures position had a gain of 1.03.  The net result of the hedge is a gain of 51 cents per bushel.

The net price received for the corn is calculated by adding the change in futures to the cash price at which the grain was sold.

-OR-

The farmer had a goal of getting $5.52/bu of corn when he placed the hedge.  The result of basis strengthening allowed him to actually achieve a price of $6.03/bu.

Add Hedging To Your Plan

Hedging is a great risk management tool.  Yes, the corn prices in the example could have increased and the farmer would have lost money in futures and gained money on cash grain.  If that was the case, a user could have benefited by placing a long hedge!  Remember, the goal of hedging is to transfer price risk and set the prices one will receive or pay within a roughly determinable range.  Reducing exposure to market surprises allows producers and users to plan their operations more confidently.