Many farmers fail to distinguish between “true” and “selective” hedges. However, knowing the difference before you put the hedge in place can be integral to whether it is ultimately deemed a success or a failure.
Some of the hedges will be “true” or “conservative” hedges.
These are hedges that are held until an offsetting sale is made in the cash market. In other words, the hedge is held until a sale of a corresponding amount of physical grain is sold.
For example, a farmer may be concerned that a big South American soybean crop this year will pound prices lower before he or she has an opportunity to sell more new-crop soybeans. In that case, the grower may buy a put option on the November 2023 soybean future. They will hold that put option as protection against lower futures until a cash sale is made. That is a “true” hedge.
Alternatively, consider the situation last spring. Wheat futures were extremely high after Russia invaded Ukraine. A farmer wanting to take advantage of that strength without committing to selling more physical grain might want to set a “true” hedge using a short position in Chicago wheat futures or put options.
Other times, a farmer with grain in storage might look at the futures markets for corn or wheat and see a larger “carry” in the market, with deferred futures contracts priced well above the nearby contract. In that case, they might buy a put option on one of the higher-priced deferred futures as a “true” hedge against the grain they have in storage. The put option could offer them some protection in the event the higher-priced deferred futures eventually move lower towards the cash market.
Other hedges will be “selective” or “temporary” hedges.
These are hedges that are placed based on market signals, and these hedges will be lifted when the market signals change. A so-called "selective" hedge might be held for just a few days or weeks. If the market immediately goes in the expected direction, the farmer may take profit on the position by exiting it. Or, if the market goes against the position, the farmer may cut their losses by getting out of the position.
Think of the case where a feed buyer is nervous that a USDA report could send an already expensive market even higher. Since the market is deemed to already be expensive, buying more feed in the cash market may not be attractive. Instead, the feed buyer may go long corn futures or buy a call option as a “selective” hedge. This position could offer protection in case futures shot higher after the report, while allowing the feed buyer to get out for a small loss if the market does not go higher on the news ̶ in this case the USDA report.
Key point: Hedging is optional. It entails risk.
It is not a necessity for all farmers to hedge. Sometimes hedging can complicate the decision-making process and become a liability, rather than a benefit.
“Hedging in certainly not suitable for everyone,” commented Ranulf Glanville, a market analyst with GrainFox.
“Depending on circumstances, market conditions and risk tolerance, farmers may want to add to sales in the cash market – or do nothing! – instead of hedging. Hedgers should be aware of the complexities and risks involved. In most cases, it’s vital for hedgers to limit their exposure if the market does not perform as expected. I’ve also seen more than one ‘hedge’ program drift into speculation, with disastrous financial results,” he concluded.
Source: DePutter Publishing Ltd.
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