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Taking The Edge Off With Futures And Options

“I pounded my head against the wall. When you say those words – ‘I think,’ ‘I hope,’ or ‘It’s gotta go higher’ – you’re speculating.”

– TOM CLARK, CME

There are a few surefire ways to avoid the unpredictable nature of commodity markets.

One way out of the lowest-price-is-the-law trap is to direct market all of your production, making you the price-setter, not the price-taker.

Another is to quit farming altogether, and get a job in town.

But for those who want to continue with business as usual as grain farmers or cattle ranchers, pulling up a chair in the high-stakes poker game of commodities is one way to soften the blow of price volatility.

It’s not for the faint of heart, however.

In a presentation on how to hedge against risk with futures and options at last week’s Farm Management Conference, Spencer Schellenberg recalled how a prospective client had once bragged to him about how much money he had made by speculating on agricultural commodities.

But as the conversation continued, the investment adviser from RBC Dominion Securities noticed a change in the man’s overall demeanour.

“I sensed he wasn’t happy. I said, ‘You seem upset about something.’ He replied, ‘Well, Spencer, I am. A week ago I lost $400,000 all in one day,’” said Schellenberg, at the conference held on the sidelines of the Wheat City Stampede in Brandon.

“I said, ‘Well, that’s certainly grounds for being upset.’”

The real lesson from that experience, Schellenberg said, is that if any investor thinks he’s smarter than the market, he’s wrong. But essentially, that’s what speculators do every day.

Everybody knows that by placing bets on which way the market will go, speculators can win big or lose big. What most people don’t realize is that if they themselves aren’t hedging against unexpected market moves, they’re speculating, whether they are actively playing in the market or not.

PRICE RISKS

Hedging against price swings either way can take many forms. In one case, Schellenberg helped a farmer nervous about higher fuel prices pocket US$14,000 by forward contracting fall fuel purchases in the spring.

“He didn’t have the storage capacity to have 200,000 litres of fuel delivered to his farm in the spring. So, we used a futures contract to hedge that,” said Schellenberg.

The price went up, as the farmer had expected. “We sent him a cheque, and now he can put that toward his fuel bill. All his neighbours just paid the higher fuel price.”

Bill Mitchell, also an investment adviser with RBC Dominion Securities, explained how cattle producers can play the futures market to offset risk at their local auction mart, referred to by market players as the cash or spot market.

“You’ve got to identify your price risk. Well, your major price risk, obviously, is that within the time you start feeding those cattle to the time they go to market, they have declined in value,” said Mitchell.

Offsetting that risk can be done in two ways. The standard way is to pre-sell those cattle on the futures market.

The other is by taking a short position in the futures market, betting that prices will fall.

For example, if the December price in Chicago is US87 cents per pound – an acceptable price target – a rancher can hedge against future price volatility by putting up an $800 margin payment to cover one contract which equals 33 head of cattle or 40,000 lbs. live weight.

If the price goes up to 88 cents, the hedger must fork over more cash to cover the margin call. But if it falls to 82 cents by the time the rancher sells his cattle on the cash market, the hedger gains five cents per pound on the 40,000-lb. contract.

“Then you take that $2,000 and you blend it into that (cash) price, and that’s what you’re receiving for your cattle,” said Mitchell. “If it goes up, you’ll still get whatever price it is that you hedged at. If you’re unhedged, you’ll get whatever the cash market is.”

VOLATILITY

Tom Clark, from the Chicago Mercantile Exchange, said in his presentation that structured risk management strategies based on the the futures and options markets are especially important amid the “volatility on steroids” witnessed in commodity markets today.

He recalled how a longtime hedging acquaintance, even when presented with the opportunity last year to lock in a June 2009 lean hog futures contract at $85 per hundredweight, avoided doing so because he thought the market was going higher.

Even with the $6 corn at the time, the broker’s client would have been able to make a profit at that price, said Clark. But instead of hedging five to 10 per cent of production to manage risk, the producer chose instead to hold on to his irrational belief that the price would rise.

“At that moment in time, that producer who was a bona fide hedger, turned into a speculator,” he said.

“I pounded my head against the wall. When you say those words – ‘I think,’ ‘I hope,’ or ‘It’s gotta go higher’ – you’re speculating.” [email protected]

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