When it comes to managing risk, successful producers take a no-nonsense approach to hedging. No matter if your business is facing the commodities or manufacturing sectors, limiting exposure to unfortunate trends in asset pricing is a must. Although you can accomplish this task by taking a variety of approaches, futures can be a valuable part of almost any risk management plan.
Let’s break down both a bullish and a bearish hedging example using futures. By looking at the basic mechanics of a hedge, you’ll gain a better understanding of the hows and whys behind the strategy’s execution.
Hedging Example #1: Downside Protection in the Corn Market
For any ag producer, the list of potential risks is daunting, filled with known and unknown variables. Extreme weather, tariffs, and consumer trends are among the factors that can derail a crop’s value come harvest time. Given the large initial cash outlay needed for taking a crop to market, wise ag producers often turn to futures for an added degree of protection.
In the following hedging example, Chris is an Iowa corn farmer anxious about the prospects of lagging prices come harvest time in late September. Having already invested in the planting and cultivation of 2,000 acres, Chris is looking for a way to limit risk and lock in profit for the season. Using futures, his goal may be routinely accomplished:
- With a yield estimated to be 135 bushels per acre, Chris anticipates marketing in the neighborhood of 270,000 bushels of corn (135 bushels per acre x 2000 acres = 270,000 bushels).
- In order to protect against a market downturn, Chris decides to open a short position in corn futures (ZC) listed on the Chicago Mercantile Exchange (CME).
- 54 contracts of September corn are sold, covering 100% of the projected crop yield. The position size is calculated by dividing the total projected yield (270,000 bushels) by the quantity of one corn futures contract. (5,000 bushels).
As soon as the short position is opened at market, Chris will financially benefit from any drop in corn prices. The gains realized from futures will work to offset losses sustained in the cash market, thereby boosting aggregate profitability.
Hedging Example #2: Insulation from Inflation
In a similar vein as commodity producers, the manufacturers of finished goods and services face a variety of potentially dangerous risks. At the top of the list is an untimely spike in the price of raw materials.
In this hedging example, assume that Gentry the jeweler is convinced that a run on silver is likely to develop over the coming Christmas holiday season. Crafting sterling silver earrings, necklaces, and flatware is the core of Gentry’s business, which means that a significant uptick in silver pricing raises production costs can hurt orders from wholesalers. Fortunately for Gentry, futures can be used as protection from such a scenario:
- Gentry estimates that beginning in October, 5,000 troy ounces of silver per month will be needed to fill holiday orders.
- Accordingly, Gentry purchases 3 contracts of December silver futures listed on the CME. Each contract’s quantity is 5,000 troy ounces, a total long position of 15,000 troy ounces. This position offers 100% coverage for the 15,000 ounces of silver (3 months x 5,000 ounces per month = 15,000 ounces) that Gentry will need to conduct business.
When the position is opened at market, Gentry will realize gains from any bullish move in silver pricing. While rising prices will raise operational costs, the profits from being long silver futures will work to limit any losses sustained from cash purchases of silver.
Want to Learn More About Hedging?
Both hedging examples above are extremely basic looks at how futures may be used to mitigate downside producer risk. In reality, defensive hedging is an art form, with plans quickly becoming sophisticated.
To learn more about the ins and outs of risk management via futures, check out the online hedge portal available at Daniels Trading. Featuring a collection of unique services, the team at Daniels has the market savvy to help you optimize your business.