Master marketing tools: Are you using the right risk management tools?
Just like the array of tools in a well-stocked shop, it pays to have access to the right marketing tool for each need.
Early season grain price volatility used to be largely driven by weather. Today we have weather effects, plus other influencers, including trade agreements, global health concerns and renewable fuels demand. Now more than ever is a good time to leverage risk management tools.
Always start with a good marketing plan based on understanding all your costs and your profitable target price. No one knows when the market will spike, so set your plan, understand the tools and place your orders ahead of time so you can act quickly when price opportunities occur.
Futures: The Hammer
Think of futures like a hammer: a simple tool with one primary purpose: to lock in a price for protection against a market downturn.
A futures contract is a relatively simple tool; you’re either in the market or you’re out. When the futures market rallies to a price that is profitable for you, simply sell futures for the month you are most likely to deliver the grain. That includes locking in a price for a crop you haven’t planted yet.
Let’s say you sell a July 2020 corn futures contract at $4.00. If the futures market is below $4.00 in July (when you sell your grain to your elevator and immediately buy futures to close out your futures position), you gain money on your hedge. At the same time, you will likely see your cash inventory go down in value because futures and cash prices tend to move up and down together. Conversely, if the market goes above $4.00, you lose money on your hedge, but you should gain on the cash side.
Using futures impacts cash flow. You have to post initial margin any time you trade futures to cover potential losses in your account. For example, a recent corn futures contract (a fixed quantity of 5,000 bushels × $4.00 per bushel) has a value of $20,000. The amount of initial margin you are required to pay is roughly $1,500. In return for posting margins, a producer gains a $20,000 tool to help protect a portion of inventory against price swings at harvest.
Options: A set of Screwdrivers
Just as there are many types of screwdrivers for different tasks, there are different choices associated with option contracts.
When you buy an options contract, you have the right to buy or sell an underlying futures contract, but you don’t have to exercise that right — you can offset it or let it expire. You do not have to post margin when buying options because you pay the full value up front.
When you sell an option, you always have that obligation, but you get to collect the premium to assume the risk. If you pick a strike price (the price at which you get to exercise your option on futures) near the current market price, it costs more.
Call options give you the right to go long in underlying futures. Put options give you the right to go short. Think of calls like buying and puts like selling. As prices go up, call options gain value and put options lose value.
Minimum price example using a call option: You would buy a call option when you think prices might go higher and you don’t want to have buyer’s remorse because you sold your cash inventory too soon. Let’s say December 2020 futures are trading at $3.90 per bushel and your cash price is $3.70. You sell your cash corn at $3.70 and buy a $4.00 call option for 22 cents, establishing a cash floor of $3.48 ($3.70 minus 22 cents). If futures spike, you participate in that upside, but the market has to reach the strike price before you benefit.
Minimum price example using a put option: You would buy a put option when you expect the market to go lower. Say December 2020 futures are $3.90 bushel and the cash price is $3.70. You buy a $3.70 put option for 14 cents, establishing a cash floor of $3.56. If the market starts to move higher, you participate in that upside penny for penny. Your downside is protected because you have the put option in place.
How you use the options tool will depend on your situation. Producer A wants to sell corn, but worries prices will go higher, so he buys a July $4.20 call for 10 cents and sells the cash position. In that case, the producer’s basis and cash positions are covered and there’s no margin payment on the option. Producer B is willing to sell corn if the market rallies, so she sells a July corn $4.20 call for 10 cents. The producer is comfortable leaving the cash and basis side open, knowing higher margins will be needed if the market goes up.
OTC Contracts: The Welder
Like a welder, over-the-counter (OTC) contracts are more complex, but can be an extremely powerful tool when used at the appropriate time.
CHS Hedging offers OTC contracts through local cooperatives and elevators, which producers can access through a CHS Hedging Compass contract. One example is the Price Builder Bonus contract. Say the contract offers a price of $4.15 with a $3.60 trigger price. If you choose to contract 3,000 bushels over 300 days, you will price 10 bushels daily until either the trigger price is hit or the 300-day period ends. If futures are trading at $3.90 on day one, you price 10 bushels at $4.15 and earn a 25-cent bonus. You continue pricing 10 bushels at $4.15 every day for the next 299 days unless the market drops to $3.60 or below, at which point no more bushels will be priced. On day 300, if you’re still pricing bushels and the market price is above $4.15, you are obligated to sell an additional 3,000 bushels at $4.15. You might end up selling only 10 or 100 bushels, or you might sell 6,000 bushels. OTC contracts are flexible, so your local elevator can offer you a Compass contract that is tailored to your needs, including contracting any number of bushels.
More Marketing Tool Ideas
- AgSurionSM Risk Consulting, a service of CHS Hedging, uses a proven model to help producers develop smart risk management plans.
- A CHS Pro Advantage contract can extend and diversify your marketing program by authorizing experienced trading experts to price a portion of your grain inventory.
LEARN MORE: Find out how CHS Hedging pros can help give you more confidence and less worry at chshedging.com.
Check out the full C magazine with this article and more.
This material has been prepared by a sales or trading employee of CHS Hedging, LLC, and should be considered a solicitation. There is a risk of loss when trading commodity futures and options.