Producers of agricultural commodities are faced with price and production risk over time and within a marketing year. Furthermore, increased global free trade and changes in domestic agricultural policy have increased the price and production risks of agricultural producers. As price and production volatility increase revenue variability, producers are realizing the importance of risk management as a component of their management strategies. One means of reducing these risks is through the use of the commodity futures exchange markets. Like the use of car insurance to hedge the potential costs of an accident, agricultural producers can use the commodity options markets to hedge the potential costs of commodity price volatility. However, like car insurance in that the payments from a small insurance claim may not exceed the cost of the premiums paid, the gains from hedging agricultural commodities may not cover the costs of hedging. This guide was designed to introduce agricultural producers to hedging and aid them in better evaluating hedging opportunities. This guide is intended to provide those interested in understanding hedging an introduction, and it provides those more advanced in the understanding of hedging a refresher. The primary objective of hedging is not to make money. The primary objective of hedging is to minimize risks and this includes using hedging to minimize losses.

The options market is sometimes referred to as insurance. Why? Because by hedging through the options market an individual locks in the costs of hedging and then can lose at most only the cost of the option premium while having unlimited profit potential. Alternatively, holding a futures position limits profits and losses by the hedged price.

Commodity Trading: The Operations of a Commodity Exchange

Trading is the process whereby a commodity is simultaneously bought and sold in two separate markets to take advantage of price discrepancy between the two markets. A commodity futures exchange acts as a market place for persons interested in Trading. The factors driving Trading are the differences and perception of differences of the equilibrium price determined by supply and demand at various locations. For instance, suppose there is a shortage of corn in North Carolina to feed livestock. If I believe that I can profit from buying corn in Missouri, paying shipping costs, and selling corn in North Carolina, I will continue to do so until the supply and demand for corn are equal in North Carolina, thus the Missouri corn price plus the shipping costs equal the North Carolina corn price.

For the options market, the Trading activities are carried out through the exchange of paper promissory notes to sell or buy a commodity at an agreed upon price at a later date. This promissory note gives the individual the right to either buy or sell at a later date and not the obligation to buy or sell as with futures hedging. As new information enters the market (exchange), peoples perceptions change and the process of arbitraging begins again. Options change in value due to the perception of traders of where the market will go in the future.

Where does Trading Occur?

There are two main locations where trading occurs for agricultural commodities. As obvious by their name, Chicago is the location of both of these main futures exchanges. The Chicago Board of Trade (CBOT) is where the agricultural commodities corn, soybean, soybean oil, soybean meal, and wheat futures are traded. The Chicago Mercantile Exchange (CME) is where the agricultural commodities lean hogs, live cattle, feeder cattle and stocker cattle are traded. In addition to these commodity markets, cotton is traded at the New York Cotton Exchange (NYCE), rough rice is traded at the MidAmerica Commodity Exchange. Please refer to publication Agricultural Commodity Futures Contract Specifications for more details on commodity exchanges.

Options Terminology

Before proceeding, a few careful notes are needed as to the terminology used with the options market. A put option gives the individual the right but not the obligation to sell a futures contract at a later date. A call option gives the individual the right but not the obligation to buy a futures contract at a later date. The price at which the futures market can be entered at a later date is referred to as the strike price. The premium paid is in relation to the strike price. The strike price is a predetermined range of values that is different for each commodity. A put (call) option is said to be in the money if the strike price is above (below) the underlying futures price. A put (call) option is said to be at the money if the strike price is equal to (equal to) the underlying futures price. A put (call) option is said to out of the money if the strike price is below (above) the underlying futures price. At any given time, the range of strike prices quoted will cover values in the money, at the money, and out of the money. Thus, a hedger or speculator has the option of purchasing an option at any of these three levels. Typically, options in the money will have the highest premium, followed by options at the money, and options out of the money will have the lowest premiums.

There are two components which make up the value of the option, intrinsic and time value. Both of these values are implicit values not observed, but theoretically present. Intrinsic value is the value of the option relative to the underlying futures price. That is, a $76/cwt. Put option for feeder cattle has an intrinsic value of $2.50/cwt. if the underlying futures is priced at $73.50/cwt. This is due to the fact that the Put option could be exercised (sell a futures contract at $76/cwt. and buy back at $73.50/cwt). Typically, the change in intrinsic value of the option is determined by the change in futures price. However, the change in option price is typically not as large for out of the and at the money options. Additionally, there is a time component to the value of an option. The time value reflects the time between the option premium quote and contract expiration. Typically, the larger the time period the greater the implicit time value of the option. That is, the greater number of days until contract expiration, the higher the probability of the futures market changing in value enough to improve the intrinsic value of the option.

Example

Bill believes the domestic fall production of corn has been under estimated in mid-summer, and Tom believes the domestic fall production of corn has been over estimated in mid-summer. Using the commodity exchange as a market place, since Bill believes corn prices are destined to go lower, Bill purchases the right to sell a futures contract (Put) at a predetermined price at a later date, and Tom purchases the right to buy a futures contract (Call)at a predetermined price at a later date because he believes the price is going to go higher. Unlike the case of the futures, Bill and Tom will not off-set each others position. In the options market there are writers of options. These people are like an insurance agency. A writer of an option is willing to take a set premium per unit of commodity in exchange for the risk that the commodity price may move against them.

Suppose Bill purchases the right to sell (put option) a future contract for corn at a later date at a strike price of $2.60/bushel for a premium of $0.15/bushel and the futures price is at $2.70/bushel that day, then Bill would initially pay the commodity broker $750 (5000 bushels multiplied times $0.15) plus commissions. The $750 would go to the writer of the option. Anyone can write options. Why would anyone write an option? Because if the price does not decline or the price rises the premium would decline over time and the option writer would profit $750. However, the futures market price could have decreased to $2.40/bushel and the premium increased to $0.35/bushel. Note, generally there is not a one-to-one relationship between a change in the futures market price and option premiums due to less risk in the options market. Thus, Bill could now either sell the option for $0.35/bushel and profit $0.20/bushel ($1000) or exercise the option. Exercising an option should only be done if there is concern as to the liquidity in filling an order to sell the option. More detail on the exercise of an option can found in the options examples of this guide series.

When to Hedge

By knowing his cost of production, Joe can determine at what prices he might consider forward pricing a portion of this crop. Thus, it is imperative that a producer know his/her cost of production when hedging a commodity. For instance, if Calvin knows his cost of production on 400 pound feeder calves is $60/cwt., then Calvin might consider forward pricing a portion of his calf crop through the options market when Calvin wants to cover his cost of production. It is important that persons determine a target profit margin, because persons have a tendency to always want to price at the market high. Some words of advice, it is nice to say you received $5/cwt. more on your calf crop than your neighbor, but it is even better to say you retired a farmer by making wise choices instead of risky choices.

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