One of the primary functions of the agricultural futures and options markets, the very foundation of this industry, is hedging, the management of the price risks naturally inherent in the purchase or sale of commodities.
In hedging, price risk is transferred from those seeking to reduce it to others willing to assume it in hopes of making a profit.
Grain hedgers include those who need protection again declining prices, such as farmers, merchandisers and grain elevators; as well as those looking for protection against rising prices, such as food processors, feed manufacturers and importers.
Hedging is essentially taking a position in the futures or options market that is opposite your current position in the cash market.
Since the cash and futures prices tend to move up and down together, any gains or losses in the cash market will be counterbalanced with gains or losses in the futures market.
Take a farmer whose crop is still growing in the field. In market terminology, he has a long cash position. In order to hedge and lock in a selling price, he would take a short position in the futures market by selling futures contracts now and buying them back later when it is time to sell his crops in the cash market.
On the other hand, livestock feeders, grain importers, food processors and others who expect to acquire grain in the future have a short cash position.
They would lock in a purchase price by taking a long position in the futures market. In other words, they would buy futures contracts now and sell them later when they are ready to purchase the grain that they need.
A good hedging rule-of-thumb to determine whether to buy or sell futures: if your future action includes selling in the cash market, an appropriate hedge today is selling futures;
if your future action includes buying in the cash market, an appropriate hedge today is buying futures.
Speculators facilitate hedging in the futures markets by taking the opposite side of most commercial trades. They are attracted to the market by the opportunity to realize a profit if they are correct in anticipating the direction and timing of price changes. In doing so, they provide market liquidity, which is the ability to enter and exit the market quickly, easily and efficiently.
A futures position is the most basic price risk management strategy for a grain seller or buyer. Again, a short position allows the seller to lock in a sell price in advance of the actual sale,providing protection again falling prices; a long position lets a buyer lock in a purchase price and obtain protection against rising prices.
Options provide protection against adverse price movements, the ability to benefit when the markets move, as well as flexibility for grain buyers and sellers. There are two basic options strategies that a grain hedger could use:
Call option: A grain buyer could purchase a call option, which gives the owner of that option the right, but not the obligation, -to buy grain at a specific price. A call option allows a grain buyer to establish a maximum, or ceiling, price for the grain he is buying, while still being able to take advantage of lower prices in the cash market should the opportunity arise.
Put option: A grain seller, on the other hand, would purchase a put option, which gives the owner of that option the right, but not the obligation, to sell grain at a specific price. A put option allows a grain seller to establish a minimum, or floor, price for the grain he is selling, while still being able to take advantage of higher prices in the cash market, should the opportunity arise.
This module only scratches the surface of the wide array of strategies that can be incorporated into a grain hedging program. No matter your concerns, CME Group grain futures and options offer a variety of flexible choices to meet risk management needs.