BY: Adam Pukalo, portfolio manager – securities and commodities futures advisor with Pukalo Prairie Wealth Group of Ventum Financial Group
What is hedging with futures and options? You may have heard these words from a neighbour, on the radio, or in a seminar but haven’t understood what they meant. Every farming operation should at least be acquainted with the basics. Consider how futures and options can give you marketing flexibility and reduce risk in your farming operation.
What Is Hedging?
Hedging is a way to offset risks associated with the volatility in grain and livestock prices or currency fluctuations. Specifically, it’s a way to help give you flexibility in your marketing decisions.
The best way I find to explain hedging is using the analogy of truck insurance. Every year you pay a premium for your truck insurance. You might never need to use the insurance, but if you get into an accident, you are glad you have it. When hedging, think of your truck as your crop and the insurance as the futures and options strategy. If an accident happens, your truck insurance compensates you for the loss. Now if the price declines on your grains or livestock, your hedging strategy could compensate you for the price decline. However, futures and options aren’t insurance products and shouldn’t be confused with your other insurance programs.
In summary, farmers can use futures and options to create a floor price (strike price minus premium paid) to protect them from price declines for their grains and livestock.
How, You Ask?
The most common strategy is buying a put option. Buying a put option means paying a premium – similar to your truck insurance – to get protection on your crops or livestock at a certain price until a specified time.
For example, in June 2022 I reviewed purchasing canola protection out until November 2022 for my clients. I’m using a year where prices were significantly higher to illustrate how using hedging strategies could be beneficial. Everyone reading, I’m sure, would like for canola to be at these levels again.
Each canola contract trades in 20 tons. In June 2022 when I implemented this strategy, the November 2022 futures contract was around $23.64 per bushel, or approximately $1040 per ton. In this example, the producer wants protection for the current market price.
Strategy: Buy the $1040 per ton November 2022 put option – Premium cost approximately $73 per ton.
This creates a floor price from June 2022 until November 2022 at $21.98 per bushel, or $967 per ton. ($1040 strike or $73 per ton premium cost).
Profit Scenario: If canola goes lower than $967 per ton….
This is important: producers sell their physical crop as normal. You get less for your physical canola, BUT your hedge account increases to offset any loss. You can sell your option at any time to take the profit. The premium you paid for your option ($73 per ton) could be worth $150 per ton depending on how long you held the option. This option protected you from the price declining because you wanted to hold the physical crop in the bin. Rather than holding it in the bin and hoping prices go up, you had protection in case they went lower.
And if canola goes higher than $1040/ton? You remove the protection.
You can either hold onto your protection or sell it if you want to recoup some of your premium. Once the option reaches half of the premium cost, consider whether you still want the protection. Some producers have said to me before, “Why did I spend this premium on the option to only get half my money back?!” My response is that nobody knows where prices will be a year from now, but it’s inevitable they will change along with supply and demand.
These types of strategies aren’t new. For years, companies in various sectors like mining, oil and gas and aviation have been controlling their risks with futures and options. Imagine the board of an aviation company having to explain to its shareholders why their revenue decreased because oil went from $50 to $70 per barrel. Shareholders wouldn’t be very happy, and they might wonder why the company didn’t manage their risk better. Your farming operation can use these futures and options strategies to give you the same marketing flexibility and reduce your risk.
Disclaimer: Ventum Financial Corp. (Ventum Financial) is a member of the Canadian Investment Regulatory Organization and the Canadian Investor Protection Fund. The risk of loss in trading commodity interests can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. This information is intended for distribution in those jurisdictions where Ventum Financial is registered as an advisor or a dealer in securities and/or futures and options.