Market side: Futures trading basics
LESSON 7: THE SHORT HEDGE
This monthly educational series will feature the basic workings of the futures and options markets and how they can be utilized to help farmers with risk management.
LAST MONTH, WE discussed how to use the futures markets to protect an end user against unexpected price rises in raw materials, which would translate into lower profit margin for that company. This month, we will look at the raw materials producers could protect against price drops while they are in possession of the same materials.
The main difference between a short hedge and a long hedge is the sector being protected. A short hedge would be considered if you were a producer or source of origin. Some examples of short hedgers would be, silver mines, copper mines, or other miners, pork and beef producers, grain producers, and any other manufacturer of raw materials.
From a farmer’s perspective, your primary concern would be falling prices for your commodity before you are ready to sell. If, for example, you decide to plant wheat because the outlook was strong for the foreseeable future and you were happy with the future price quotes, you would consider selling some of your crop against future delivery or sales. This would ensure a decent profit from your hard work and prevent a loss if the prices were to soften before you harvested and sold your wheat.
Let’s look at a typical wheat farmer and a strategy.
Assume it is February, well before the farmer will harvest his wheat, and July’s (new crop) soft red winter (SRW) futures price is $6.00 per bushel. The producer can use the July futures contract to lock in the $6 price. However, because Canadian farmers cannot deliver their grain against futures positions, this hedge must be implemented in two separate steps.
Assume the winter wheat farmer likes the price of the July SRW wheat and has an acceptable profit. The farmer can create and utilize a short futures position by selling the Chicago July wheat contract at $6 per bushel. This position would set the final price for the farmer’s grain once harvested and sold. The number of futures contracts to sell should correlate with the number of SRW bushels produced. Each individual SRW contract represents 5,000 bushels.
When the farmer has harvested and is ready to sell his physical grain for cash, he would at the same time exit, or offset, the short futures position. Assume the price of wheat dropped in this time frame to $5 per bushel. The farmer would sell his cash grain on the cash market for the lower price of $5; but his futures position, which he sold for $6, is now trading at $5. This would imply a $1 profit from his short position once he offsets the contract. The loss from the lower cash sale would be realized from the profit from the futures transaction. If the futures prices rose to $7, the farmer would realize a $1 loss on their futures short positions, but gain the $1 per bushel on their cash sale.
The purpose of this transaction is to remove the risk of declining prices for this farmer’s crop before he is able to harvest and sell his grains. Therefore, the farmer would remove the risk from price volatility, but would also remove any possible windfall profits.
This is a simplistic example, which in the case of Canadian farmers does not take into consideration the local basis and the fluctuation of the Canadian dollar. We will explore these two important components in a later lesson. •
Marty Hibbs is a 25 year veteran futures trader, analyst, and portfolio manager. Hibbs was a regular guest analyst on BNN for four years. He is currently a grain merchandiser with Grain Farmers of Ontario.
Manufacturer: A source of materials or products origin. A coffee farmer would be an example of a source of origin.