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Hedging with Commodity Futures: It’s All About Managing Price Risk!

February 28, 2011 by Drew Wilkins| Tips & Strategies

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 $4.05 and the futures price is $4.19, the basis would be -.14 (4.05-4.19). 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 $4.16 and the September futures price is $4.19. 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 $4.16/bu for corn. Each corn futures contract contains 5,000 bushels. The farmer sells two September 2018 corn futures contracts at $4.19 on 2/23/18.

It is now September and the farmer’s instincts held true. Cash corn prices are currently at $4.00 and September futures are trading at $4.50. The farmer sells his grain in the cash market and offsets his position in the futures market on 8/28/18.

Change in Basis

Date Cash Futures Basis
02/28/2018 4.16 4.19 -.03
08/28/2018 4.00 4.50 -.10
= -.16 = +.31 =.15

The farmer lost -.16 on the cash side, but his short futures position had a gain of .31. The net result of the hedge is a gain of 15 cents per bushel.

0.15/bu (Gain in dollars/bu)
X 5000 bu/contract
$ 750/contract
X 2 contracts
$1,500 gain in dollars

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.

Cash Price Received: $4.00/bu
Gain on Futures: +.31/bu
$4.31/bu

-OR-

Target Price: $4.19/bu
Adjusted by net result: +0.15/bu
$4.31/bu

The farmer had a goal of getting $4.19/bu of corn when he placed the hedge. The result of basis strengthening allowed him to actually achieve a price of $4.31/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.

Filed Under: Tips & Strategies

About Drew Wilkins

Drew received his B.S. in Agricultural Business from the University of Arkansas. Growing up in Arkansas, he was always familiar with agriculture. However, it was a Futures and Options class in college that sparked his interest in making a career out of the markets. “Learning more about the overall marketplace was fascinating. From hedging to speculating, the futures markets offer a risk management and investment avenue not found anywhere else.”

Since joining Daniels Trading, Drew has helped his many clients navigate the markets. He prides himself in being diverse in his execution abilities. Whether you are looking to enter a multi-leg option spread or enter a market order online, he can help you get it done. Drew knows that not every client is the same. One of the aspects he enjoys most is working with new clients and helping them formulate a plan on how they want to approach the market.

When out of the office, Drew enjoys playing golf, flag football and cheering for the Razorbacks.

Risk Disclosure

The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.

Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.

© 2023 StoneX Group Inc. All Rights Reserved

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Risk Disclosure

The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.

Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.

© 2023 StoneX Group Inc. All Rights Reserved

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