There are many risk management strategies for price protection during uncertain markets. These strategies are necessary for grain and oilseed producers and sellers, such as farmers, merchandisers, grain elevators and exporters.
The circumstances for each hedger is different, and their hedging needs are specific to their goals and objectives and the financial status of their business operations, as well as their own level of risk tolerance.
Because of this, there is no one, perfect strategy that will fit all hedgers in all market conditions, nor is there one strategy that an individual hedger will want to employ in every scenario.
The short hedging strategies addressed in this chapter, while among the most common, are not an exhaustive list of all the strategies available. All short hedgers should become familiar with the various risk management alternatives, and which ones may work best for their particular needs.
This module will review short hedging strategies and compare their pros and cons.
For the purpose of our comparison, we will use the case of a soybean farmer who planted his soybeans in the spring and is looking to hedge between now and when he harvests his crop in the fall.
Assume the November Soybean futures price is currently $10 a bushel. For the sake of simplicity, we will disregard the issue of the basis and use hypothetical prices for Soybean futures and options.
The short futures position is the most basic strategy for a grain seller, providing price protection against the risk of falling prices. Say that the farmer goes short November Soybean futures at $10.
The key advantage is that it allows him to lock in the $10 selling price in advance of the actual sell. If futures prices fall between the spring and November, his selling price is protected. However, one of the disadvantages to this strategy is that it does not allow him to benefit from higher prices if soybean prices rally.
If the farmer would like protection against falling prices, but still retain the ability to sell at a higher price if futures rally, he may prefer the flexibility of a long, put option. For example, buying an at-the-money put with a strike price of $10 for a premium of 50 cents.
Buying the put establishes a minimum, or floor, selling price of $9.50, the strike price minus the premium, while retaining the opportunity for the farmer to get a higher net price if the market rallies.
As the buyer of the put option, the farmer will not be required to post a performance bond, but he does pay the 50-cent premium upfront for the protection and opportunity that the put option provides.
In a stable market environment, a short, call position may provide the farmer with the best net selling price, but it is a riskier strategy.
Say the farmer sells an at-the-money soybean call option for which he receives the 50-cent premium. As long as the market actually remains stable, he will retain the 50-cent premium, which will allow him to effectively increase his net selling price.
However, the effectiveness of this strategy is contingent upon the market remaining stable. The short call option establishes a maximum selling price of $10.50, the strike price plus the premium, which limits the farmer’s ability to participate in a market rally.
Also, should the soybean market decline significantly, his downside protection is limited to the 50-cent premium he received for selling the call option. In addition, as the seller of the call, the farmer will be required to post performance bond at the time he sells the option.
The farmer can also combine a short, call position with a long, put position, which will allow him to establish a selling price range for his soybeans. For example, he could buy an out- of -the-money put option with a strike price of $9.40 for a 9-cent premium and simultaneously sell an out-of-the-money call option with a strike price of $10.60 for which he receives a premium of 10 cents.
He establishes this position at a net premium of 1 cent credit: the 9-cent premium he paid minus the 10-cent premium he received.
The long put establishes a floor price of $9.41, the $9.40 put strike price plus the net premium, and the short call establishes a ceiling price of $10.61, the $10.60 call strike price plus the net premium.
The advantages of this strategy are that it creates a known selling price range; the farmer knows upfront the maximum, as well as the minimum, price he will receive for his soybeans—and the premium he collects allows him to establish a higher floor price level than he would have by simply buying the put option.
However, the disadvantage is that it limits the opportunity to participate should the market rally above short call strike. Also, as the seller of the call option, he will be required to post a performance bond for that side of the trade.
The farmer also has the alternative of doing nothing, the most simplistic, but also the riskiest strategy for a grain seller.
While this may yield a higher selling price if the soybean market rallies, it provides no protection at all in the event of a market decline.
There are many strategies available to grain sellers to manage risk involving futures, options, the cash market, or a combination of these, each with their own advantages and disadvantages. It is important for hedgers to become acquainted with all of their alternatives and understand when a specific strategy should or should not be used. Remember that a strategy that was effective for hedging one sale, may not be the best choice for the next.