Pre-Hedging Your Cash Grain Purchases

It is harvest season with a bumper crop upon us.  How do you plan to pre-hedge your cash purchases of grain during the afternoons and weekends when the futures markets are closed?

One typical method is to estimate how many bushels will be arriving, and then sell the corresponding number of futures contracts.  This strategy could lead to under- or over-hedging situations, with potentially unlimited risk in the futures market.  However, a different tool—weekly option—could define your risk and still possibly leave room for upside profit.

The advent of weekly options in the Grain and Oilseed complex provide grain elevators with an alternative that helps mitigate risk while preserving the ability to offer cash bids off hours.  Trading alongside standard and serial options, the listing of weekly options means that there is an option expiration every Friday. This allows access to a very short-term option that has little time value and potentially lower premiums, as well as the ability to time your trade according to your needs. 

Pre-Hedging Cash Purchase with a collar

A collar is an options strategy that involves buying a put option for downside protection and selling a call option to keep upfront costs down.  The strategy gives an elevator a pricing window that guarantees a minimum price for bushels at the same time capping the maximum price.

If an elevator was to enter into a collar on a Friday going into the weekend using a one-week option, an elevator would have the assurance to be able to sell futures at the strike price of the put option.  Depending on strike prices and current futures market this strategy could be done for zero premium cost or even a credit.

The elevator has the flexibility to price the grain in the futures market between the put strike and the call strike at any point before the weekly option expires (7 days). For example, if Soybeans are trading at 935 on Friday, you could buy the 930 put, sell the 940 call. This strategy should have very little premium costs involved.

Figure 1:

Your best possible hedge would be 940, your worst hedge would be 930. At any point you can sell futures between 940 and 930, locking in the hedge via the futures market. You would then want to exit out of the short call positon if the option has not expired so you are not double hedged.

Benefit over hedging with Futures

The biggest risk of pre-hedging in the futures market is selling too many futures on Friday to offset cash grain purchased over the weekend, and having futures rally on Sunday night/Monday morning.

With a collar, you sell out of the money calls, which opens up the possibility to having the obligation of selling futures at the call strike price.  The call strike price will always be higher than where the futures market is trading before the weekend. In the chance that futures rally, extra sales of out of the money call options will be better positioned than futures positions that do not have a cash hedge associated with it.

Summary

Weekly options can give the hedger short-term coverage on cash purchases at a low premium outlay. It also can allow for a pre-hedge that is flexible with a defined risk, while retaining the possibility to realize profits.

See where weekly options are currently trading: Corn | Soybeans | SRW Wheat | Soybean Oil | Soybean Meal

Helpful tools from QuikStrike

 

For more information, visit www.cmegroup.com/weeklyags or contact:

Steve Stasys, Director

Commodity Products

Steven.stasys@cmegroup.com

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