Hedging Using the Futures Market
Hedging is a strategy used by many people to protect against price risk within a market. Grain futures markets are no strangers to volatility and can have very large price swings in short amounts of time. This increased price volatility makes the already risky agricultural business even riskier. Agricultural producers and merchants already have a long list of uncontrollable variables that have to come together to make a profitable business such as weather, equipment, interest rates for equipment, and policies that affect agriculture etc. By utilizing hedging strategies, producers and merchants can work to control their selling or buying prices and to eliminate part of the risk associated with agricultural production and marketing.
Futures hedging is something that has been researched and studied for decades. Burdine 2013, explains that the “straight hedge” is one of the simplest forms of hedging available. The idea behind the “straight hedge” is taking an equal and opposite position in two markets that have a strong correlation so that gains in one market can offset losses in the other. For example, if a farmer wants to hedge 5,000 bushels of corn in May for November cash delivery, he/she would sell one December corn contract now, in May, to lock in their selling price. This strategy can lock in selling prices for producers and buying prices for merchants. It is important to know that the objective of hedging isn’t to make a profit with the hedge, it is to minimize risk (Foreman 2000).
In order to use futures hedging, it is important that the market participants understand their position in the market. Grain farmers are considered to be short (sell) in the cash market in the future, therefore they take a short position in the futures market when the hedge is placed. The hedge is lifted when the producer harvests his/her grain and sells it on the cash market while simultaneously buying back his/her futures position. These hedging strategies are considered “short hedges.” On the opposite side, end users such as feed mills and processors are long (buy) in the cash market in the future, therefore they take a long position in the futures market when they see favorable prices. The hedge is then lifted when the user purchases the grain on the cash market and simultaneously sells its futures position. These hedging strategies are considered a “long hedge.” Producers hedge to protect themselves against falling prices while merchants hedge to protect themselves from rising prices. It is also important to know that futures contracts cannot be traded by just anyone, the interested party has to go through a licensed broker that is able to trade through the exchange. This process involves commissions and fees. These fees and added costs have to be considered when thinking about the practicality of placing a hedge. Below are the steps that should be considered in futures hedging.
The first thing to consider when hedging is the firm’s breakeven selling price. This calculation is important because it determines the minimum price that a firm can sell its product for while still covering its costs (Hofstrand 2018).
Breakeven Sale Price = (Total Fixed Costs / Expected Production) + Variable Cost per Unit
It is also a good idea to calculate the breakeven price for multiple different production outcomes, or throughout the growing season, as there are many factors that can affect yield. This allows the firm to have a more accurate breakeven and in turn helps the firm make better hedging decisions based on what the likely production outcomes are.
The second step is finding the appropriate futures contract that fits the firm’s hedging objective. Grain futures are designed to have contracts in months that reflect the seasonal patterns for planting, harvesting, and marketing the crop (CME Group). Therefore, it is important to understand why you are hedging and when you plan to make a cash sale and lift the hedge. This will help determine what contract month is desired for the hedge. It is important to note that most grain futures contracts expire on the business day prior to the 15th day of the contract month. This means that it is important to choose a contract that expires close to but after your expected cash delivery date. This will ensure enough time to offset the futures position and lift the hedge when the cash delivery takes place.
The next step needed before the hedge is opened is the calculation of the firm’s target price for the hedge. The target price represents the selling price that will be locked in with the short hedge:
Target Price = Futures Price + Expected Basis
The target price has two components, the futures price, and the expected basis. The futures price that is used is the price at which the firm seeks to enter the hedge with. This equation demonstrates that the higher the futures prices at which the hedge is initiated the higher the selling price that the hedge locks in. Most producers watch the markets to pick favorable times for placing their hedges. The expected basis is the basis the firm expects to receive when the hedge is lifted. This can be calculated in multiple different ways using historical basis data. See the Basis section for more information on basis projections.
It is important to note that the realized selling price will be different from the target price only by the difference between expected basis and realized basis.
Realized Price = Futures Price + Realized Basis
The realized price has two components, the futures price, and the realized basis. The futures price that is used is the price at which the firm entered the hedge with. The realized basis is the basis the firm incurred at the time of physical asset delivery. Thus, hedging removes price risk but not basis risk. To learn more about basis risk click here.
The fourth step to hedging is deciding how many bushels to hedge using the futures market. As stated previously, hedging typically involves taking an “equal” position size in the futures market that is held in the cash market. However, this strategy should take production risk into account. Even if 100% of a firm’s production will be sold on the cash market, there is no way of knowing exactly what that production will be until the crop is completely harvested. After the harvest is complete the grain is transported or stored where other losses to the production value can occur as well (ex. shrinkage, pest infestation, mishandling). It is important to leave room in the firm’s marketing plan for these risks. Many experts suggest that hedging approximately 70% of the expected production in the futures market is a good target. However, this amount differs for each firm as each firm has different goals and objectives as well as risk tolerance levels. The CME group offers different-sized futures contracts to help conform to a firm’s size as well. Normal grain futures contracts are 5,000 bushels, however, they also offer mini futures contracts that are for 1,000 bushels. These different-sized contracts allows market participants a bit more flexibility in their hedging decisions.
The fifth step to hedging with futures is to understand how entering a futures position through a broker works. Most brokers or online brokerage platforms make it very easy to enter or exit a futures position. Most of the time a firm can do it with a click of a button on a computer or smartphone device or they can call their broker. This eases accessibility for firms and producers; however, it comes with a cost. Futures brokers and brokerage firms offer their services for a small fee, most futures terminology uses the term “commission”. These fees differ across brokerage institutions and only account for a small portion of the futures positions but should be accounted for when calculating profits or losses from a futures hedge position.
Another unique facet to futures markets is the futures margin. The futures margin is the amount of money that you must deposit and keep on hand with your broker when you open a futures position (CME Group). There are two different types of margins for a futures contract, the initial margin and the maintenance margin. The initial margin is the amount of money that the futures exchange requires in order to open a futures position. This is important because the initial margin amounts are typically between 3-12% of the notional value of the futures position (CME Group). The initial margin makes it much easier and cheaper for firms to enter a futures position. For example, if a firm wanted to buy a December 2022 corn contract (ZCZ22) on September 15, 2022, the nominal price for that contract would be calculated by multiplying the closing price of $6.77/bushel by the contract size of 5,000 bushels, giving it a value of $33,850.00. Keeping in mind that that value is only for one contract, it would be extremely expensive and difficult for a farmer or firm to produce this kind of cash flow, especially when more than one contract is involved. This is why the futures exchange introduced the concept of margin. In this scenario, the position would be opened by the firm depositing the initial margin of $2,475.00. Instead of buying the contract at the nominal value of $33,850.00. In the days following the position being entered, the December 2022 corn contract’s price will change as new information becomes available to the market. If the market strengthens to $6.85/bushel from the initial $6.77/bushel, the margin balance will rise to $2,875.00. If the price of corn were to drop to $6.69/bushel from the initial $6.77/bushel, the margin balance would decrease to $2,075.00. This brings us to the second type of margin in the futures market, the maintenance margin. The maintenance margin is the balance at which the margin account must stay above, or else the position is canceled. In this example, the maintenance margin for ZCZ22 is $2,250.00. When the ZCZ22 price fell to $6.69/bushel, the margin account fell below the maintenance margin. This triggers a margin call. A margin call is when the futures exchange clearing house notifies the firm’s broker that the position has fallen below the maintenance margin and a deposit is necessary to continue to hold the position. The broker will then notify the firm and the firm will have to deposit cash into the margin account. One very important note to remember when dealing with margin calls is that margin accounts are always refilled to the initial margin. This means that the margin call that was issued in this case was $400.00. This example shows the importance of the margin function, which allows greater accessibility to firms and producers but also stresses the importance of a good relationship with the banker or lender. As shown in previous sections, futures markets are extremely volatile and even small changes in commodity prices can cause large swings in a position’s profits or losses. With these risks come margin calls, and in order to continue a hedge and remain in the market, the firm has to deposit money for the margin call which can get really expensive in times of high volatility. Having a good relationship with the banker or lender can help improve the firm’s ability to be able to sustain these margin calls until the position is closed.
Now that the steps have been explained to prepare for the hedge and the necessary formulas have been detailed, it is time to discuss the mechanics and implementation of futures hedging using an example. It is May and a Virginia corn producer calculates their break-even price for corn to be $4.50/bu is planning to sell corn in November, at harvest. In May (now) he goes short in the corn December futures contract at $5.50/bu in order to lock in a selling price for November. Based on the farmer’s historical records, the basis at the local elevator will be $0.40/bu in November., the target price can be calculated by adding the futures price of $5.50/bu to the expected basis of $0.40/bu, to give the farmer a target price of $5.90/bu.
Now the growing season is over and the farmer is harvesting their corn in November. The producer is looking to offset their futures position and sell their grain in the local cash market. The cash price is $6.05/bu and the futures price is $5.60/bu. With these prices, we can now calculate the realized basis by subtracting $5.60/bu from $6.05/bu. This gives us a realized basis for this hedge of $0.45/bu. the realized price from this hedge can be calculated by adding the futures price when the hedge was placed $5.50/bu and the realized basis of $0.45/bu. This gives the farmer a realized price of $5.95/bu, $0.05/bu higher than the farmer expected due to the basis strengthening at the local cash market by $0.05/bu.
Burdine, Kenneth H. “Using Futures Markets to Manage Price Risk for Feeder Cattle.” 2013.
Foreman, M. (2000, December). Introduction to hedging agricultural commodities with futures. Retrieved March 23, 2023.
Hofstrand, D. (n.d.). Crop price hedging basics - Iowa State University. Ag Decision Maker. Retrieved January 23, 2023.
