To hedge, one must take a futures position of approximately the same size as one’s own, but in the opposite price direction. As a result, a commodity producer who is naturally long hedges by selling futures contracts.
What is the best way to hedge a commodity?
Hedging is the practice of taking an offsetting position in a closely similar product or investment to reduce risk exposure. Both consumers and producers of commodities can utilize futures contracts to hedge their positions.
How do you protect yourself from rising commodity prices?
Commodity Price Risk Hedging Producers and purchasers can hedge against commodity price changes by acquiring a contract that guarantees a set price for a commodity. They can also lock in a worst-case scenario price to protect themselves from possible losses.
What is the best way to hedge a futures portfolio?
Investors who wish to hedge their portfolios must first figure out how much money they want to protect and then pick a representative index. If a $350,000 stock portfolio needs to be hedged, an investor would sell $350,000 worth of a specified futures index. The widest of the indices, the S&P 500, is a strong proxy for large-cap stocks. One S&P 500 futures contract is worth $250 multiplied by the futures contract’s price. An S&P 500 index contract would be worth $350,000 if the index price was nearly $1,400. The E-mini S&P 500 contracts, which trade alongside the main contract, are worth 20% of the standard contract’s value. Each mini-contract is worth $50 more than the S&P 500 futures contract. An investor can sell short one S&P 500 futures contract or five E-mini contracts to hedge $350,000 in equity exposure. Before the futures contract expires, the investor must either purchase it back or roll it over to the following quarterly term. In March, June, September, and December, CME S&P 500 contracts expire.
How do futures contracts protect you against risk?
Hedging is the practice of buying or selling futures contracts to safeguard against the risk of losing money due to fluctuating cash market prices. If you’re feeding hogs to market, you’ll want to hedge against dropping cash market prices. If you need to buy feed grain, you’ll want to hedge against rising cash market prices.
When is it appropriate for a trader to sell futures to hedge an asset?
When an asset is projected to be sold in the future, it is usually ideal for a hedger to use. A speculator, on the other hand, who believes the price of a contract will fall, can use it. 1.
How do you protect yourself against cattle futures?
Hedging is one of the marketing methods available to livestock farmers that want to price their animals ahead of time. Hedging safeguards against price changes that are unfavorable.
Two types of hedgers
Hedgers are divided into two types: those who guard against a price drop (short hedge) and those who protect against a price rise (long hedge) (long hedge).
Short hedgers are livestock producers that expect to sell their animals in the future but want to protect themselves from price drops. If a producer sells a futures contract, they become short hedgers (futures contracts that are applicable tothe type of livestock they plan to market).
Short hedgers are the polar opposite of long hedgers.
Long hedgers require a product at some point in the future, don’t want to buy it now, and want to protect themselves from a price increase. If a producer purchases a futures contract, they become long hedgers (futures contract applicable to the type of feed or feederlivestock they plan to purchase).
A cattlefeeder, for example, who plans to put feeder cow in the feedlot in three months but wants to set a price and protect against a price rise in those three months is an example of a long hedger. To hedge against a spike in cash prices, this hedger would purchase feeder cattle futures.
Buying corn futures to fix a price for corn and protect against a price rise is another example of a long hedge by a livestock producer.
Placing a short hedge
Hedging may be appropriate for a producer who is feeding animals, intending to market them later, and wants to set a price now rather than risk price declines.
The first step is to choose the right futures contract, one that matures around the time the livestock is to be sold. Contracts are not available for every month of the year, unfortunately. In January, for example, a producer might expect to sell hogs or cattle. Contracts for hogs and cattle do not expire in January. In such instances, the producer should choose for the contract that expires one month after the livestock are sold. As a result, if a producer wants to hedge hogs or cattle in January, the February futures price should be used. The reason for choosing a contract that matures after the animals are sold is that the futures contract can be offset when the livestock are sold.
Adjusting the futures price for the expected basis, as illustrated in Example 1, is the most typical way of localizing the futures price. At marketing time, the basis represents the projected difference between the local cash price and the futures price (see Basisfiles under Information Files). Understand the differences between the Livestock Basis, the Lean Hog Basis, and the Live Cattle Basis.)
The hedger can evaluate the possible returns from the hedge once the localized futures price has been determined. To get a net return from the hedge, remove three more components from the localized futuresprice. Example 2 shows how to calculate the estimated return.
If the producer wishes to hedge, he will have to pay the broker’s fee for handling futures trading. This cost fluctuates between $50 and $100 each contract (varies by brokerage firm andnumber of contracts traded, which puts the cost of trading at 15 to 20cents per cwt.).
Every contract that is exchanged requires a deposit. The initial margin deposit size varies depending on the type of livestock futures contract and the price level. Typically, the initial margindeposit will be between 5 and 10% of the contract’s value. Furthermore, if the futures market price goes in the opposite direction of the futures position, the hedger will be required to deposit additional monies.
Because the margin deposit must be paid as the market dictates (as the loss accumulates), an interest charge should be included in the cost of hedging, as illustrated in Example 3. The amount of interest charged will be determined by the direction of the futures price and the length of time the contract is held. The most one can do is make an educated guess on the interest rate.
The expected net return from the hedge is determined by comparing the adjusted futures price with the cost of production and pricing objectives as a third element in determining whether or not to hedge. Individual producers have different levels of targeted profit and price risk that they are willing to take on by not hedging. As a result, each producer must assess if the expected return from hedging is adequate.
Lifting the short hedge
Lifting a short hedge entails buying back (offsetting) your futures position and selling your livestock on the cash market at the same time. Example 4 shows an example of hedging. The hedger can disregard both cash and futures markets from the time the hedge is put until it is pulled since the gain (loss) in one market will offset the loss (gain) in the other. If the price falls after the hedge is put in place, the loss in the cash market is countered by the gain in the futures market. The increase in the cash market is offset by the loss in the futures market if the price rises. In the information file Understanding Livestock Basis, the implications of employing basis to lift a hedge are explained.
1. Purchasing a futures contract (for the same contract month that was previously sold) and simultaneously selling the cattle on the open market.
2. Delivering the livestock in accordance with the contract.
The producer should remove the futures position right before selling the livestock on the cash market when lifting a short livestock hedge. The following is the sequence of events:
1. Get a livestock cash price bid.
2. Get the relevant month’s futures price.
3. Examine the basis and compare it to previous data.
4. Purchase the appropriate month’s futures contract.
5. Sell livestock on the open market for cash.
The basis risk increases as the period between the cash transaction and offsetting the hedge grows.
Hold into contract month
Unlike grain hedgers, who are urged not to keep holdings into the delivery period, livestock producers are allowed to hold hedge positions into the delivery period. During the delivery season, the livestock base is more steady, making it more predictable than during non-delivery periods. It is not essential to lift the hedge with cash settlement contracts (lean hogs and feeder cattle). At the settlement price, the hedge will be closed out.
During the delivery period, a cattle hedger should keep an eye on open interest, or the number of contracts that are still open.
If open interest falls below 1,000 contracts, regardless of the basis, the hedge should be lifted.
Hedging in non-contract months
There aren’t futures contracts available for every month of the year. As a result, the livestock producer may have livestock ready to sell in months when no futures contract is available. Non-contract months are riskier to hedge than contract months. The non-contract months’ base is less stable than the contract months’.
Hedging and quality
Producers who sell livestock that isn’t of the grade stipulated in the futures contract run the risk of incurring additional basis risk. Select grade cattle discounts, as well as carcass premiums and discounts, should be considered into the basis.
How are futures contracts used by farmers?
Futures contracts are used by farmers to lock in a price and mitigate price risk. A maize producer, for example, might elect to sell a corn futures contract in May, after planting is over, for delivery in December.
How do farmers use futures to protect themselves?
A farmer, for example, is an example of a hedger. Farmers plant cropsin this case, soybeansand are exposed to the risk that the price of those soybeans will fall by the time they’re harvested. Farmers can mitigate this risk by selling soybean futures, which can help them lock in a price for their crops early in the season.
What are the dangers of storing commodities?
Commodity risk is defined as the uncertainty of future market values and the magnitude of future income caused by changes in commodity prices. Grain, metals, gas, energy, and other commodities are examples of these commodities. The following types of hazards must be addressed by a commodity business:
- Price risk arises from adverse changes in global prices, currency rates, and the basis between local and global pricing. The connected pricing area risk has a minimal influence most of the time.