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Choose the appropriate strategy

Al Kluis 02/14/2013 @ 10:11am

I enjoy teaching at the Lafayette Trading Academy (LTA), where I get the chance to work one-on-one with the farmers who attend. The students, mainly farmers, are anxious to learn more about grain marketing and trading. I also find that as I am preparing the syllabus and the slideshow for the classes, it forces me to think of different ways to approach decision making.

During my second year at the LTA, Corey Redfield, another instructor, showed me a slide that he had put together called Appropriate Strategy for Given Market (see Table 1 below).

The left vertical axis represents your Market View and defines your hedging needs. Are you bearish and need to sell or get short futures to hedge your risk? Think of a corn farmer raising corn who needs to hedge (sell) his corn crop. The other view is that you are bullish and need to buy or get long to hedge. Think of a hog farmer who needs to get long (he buys corn or corn futures).

The horizontal axis represents your Volatility View. This is relative to how much volatility is priced into the option market. Options are more likely to be higher in volatility during a summer weather scare than they are at the end of February. When you evaluate your Volatility View, you can use an option analyzer.

Another alternative is to look at complex option analytics like delta, theta, and gamma. I prefer my own method, which is to look at the time of year. I know from historical odds and the time of year when the volatility is likely to be low or at an extremely high level. These historic odds do not work all the time, especially if you get an extreme market movement in the grain markets because of outside market factors.

There are many ways you can use Table 1. A perfect example happened last August when grain prices were going straight in a weather-driven bull market. I had a call from a new customer, a young farmer, who said, “I know I need to do something, but I don't want to do the wrong thing.”

How market view works

I began by asking him a lot of questions about his crop and his crop insurance. I asked him how much he had sold and how he had sold it. I asked if he was familiar with futures and options, and if he had an elevator or broker where he could put on hedge-to-arrive contracts. Without knowing it at that time, I was getting this young farmer's Market View.

For this nervous young man, it was all positive news. He had great yield potential, he had RP crop insurance at 80%, and he had only priced 10% of his insured bushels. He was bullish, but he acknowledged that he usually was, and he did not want to miss it.

It takes a long time for a futures contract to expire. See example above regarding December 2013 corn. Looking ahead, you can already trade December 2016 contracts.

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