Inside The Futures World
Want to find out how the futures markets really work? DeCarley Trading senior analyst and broker Carley Garner responds to your questions about today’s futures markets. To submit a question, post your question at http://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C. Visit Garner at www.DeCarleyTrading.com. Her books, Commodity Options and A Trader’s First Book On Commodities, are available from FT Press.
HEDGING PRICE RISK
Is there a way to hedge price risk in the futures market without giving up potential for favorable price movement?
The goal of a perfect hedge is to eliminate the price risk exposure in any particular market. In doing so, however, the end user also gives up any favorable price movement.
Hedging is like any other form of insurance; consumers pay a premium to insurance companies to protect themselves from unfavorable events that will likely never occur. In other words, it isn’t possible to enjoy the benefits of protection without giving something up. But that doesn’t mean that the hedge itself can’t be strategic.
Whether you are a producer or a user of commodities, you can purchase price protection in the form of a long option. For instance, if your business consumes large quantities of gasoline and is vulnerable to higher energy costs, you can purchase insurance against prices moving beyond a certain point by buying a call option. Doing so will be expensive, but it does provide absolute protection above the strike price of the option and leave the door open for falling prices. As appealing as this sounds on paper, I don’t believe it to be the best way to hedge. After all, options have a limited life span, and the money spent buying protection when it is not needed will certainly act as a tax against any favorable price movement.
Perhaps a better way to establish a price hedge is a modification of a simple long or short futures hedge. For instance, a corn farmer expecting a yield of 20,000 bushels in the autumn might want to lock in the sales price of his crop well before harvest. Traditionally, a farmer would simply sell four September or December (depending on expected time horizon and preference) corn futures contracts (each contract represents 5,000 bushels). Doing so locks in the sales price and eliminates the risk of adverse price movement from the time the hedge is established to the time it is offset (at the time of the sale of the crop). However, it would also prevent the farmer from benefiting from higher corn prices during the same time frame. Simply stated, although this form of insurance doesn’t involve an initial cost or premium, a long option hedge would, but there is a substantial opportunity cost in the form of forgone price improvement.
In the case of a short hedger, futures contracts can be sold short incrementally as the market rallies into technically overbought levels.The optimal course of action is an attempt to take the best of both worlds. For instance, failure to use the futures markets to hedge price risk exposure in the cash market is equivalent to cash market speculation. In other words, a soybean farmer who isn’t hedging is essentially wagering on higher grain prices.
In some circumstances, this might make sense. For example, if soybean prices are at seasonally or historically low levels, it seems wise to leave some upward price potential or maybe opt not to hedge at all. On the contrary, if prices are near all-time highs, it is imperative that most of the price exposure is hedged. I recall speaking to wheat farmers in 2008; as wheat prices were peaking near $13, many farmers were holding out for higher prices ($18 was the pipe dream) rather than locking in a fantastic year, or at least hedging some of their price risk.
Ideally, a hedge should only be established if prices are expected or are likely to move unfavorably. Unfortunately, without a crystal ball it is nearly impossible to know when a hedge is optimal and when to simply let the market work for you. In essence, you can’t control the market but you can control how you react to price movement.
Hedges don’t have to be an all-or-nothing proposal; I suggest using standard technical analysis techniques to determine overbought and oversold market conditions. There are ways to implement partial hedges, or sell option premium around a futures hedge to mitigate the frustration of hedging too early and producing income to the hedger. By taking the best of both worlds, producers can reduce, but not eliminate, the price risk while giving themselves the opportunity for a blockbuster year.
In the case of a short hedger, futures contracts can be sold short incrementally as the market rallies into technically overbought levels. On the flip side, as prices fall into oversold territory, it might be prudent to sell out-of-the-money puts against already established short futures hedges. Note that this strategy should only be done in volatile and oversold market conditions.
In addition, the timing of the hedge should be in accordance with seasonal tendencies. Specifically, grain prices tend to rally from the October lows, suffer from a February break, and then rally into mid- to early summer. Therefore, it doesn’t make sense to attempt to hedge in November at a time when prices tend to be supported. On the other hand, placing incremental hedges during the spring rally could be a winning strategy.
Once short futures are in place, sudden spurts of downside volatility might create an environment in which your hedge can produce income through premium collection, or simply selling puts at distant strikes. This is similar to a covered-call strategy in stocks, but it is in the opposite direction. Because the hedger is short futures, there is no risk other than the possibility of losing the benefits of the futures hedge below the strike of the short put.