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Choose the appropriate strategy
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.
He just needed someone to tell him what he already knew he should do, which was to place short hedges on another 30% of his insured bushels and, for the first time ever, to buy some corn and soybean puts. He bought puts on another 40% of his crop. He then had a price locked in on 40% of his crop with hedges and had 80% of his crop protected with his combination of hedges and puts. As the grain markets turned lower by late September, he realized he had done the right thing.
How volatility view works
The Volatility View takes some time and study. You need to understand all of the different alternatives and choose a combination that you are comfortable with.
For many, the Do Nothing alternative is OK at times as long as you have a plan and stay informed. Unless you fully understand the risk of selling calls, puts, or strangles, that is not an advisable alternative, however.
Farming has a lot of production and marketing risks. Although this can be a profitable alternative, it usually adds to your risks. If you are producing corn or soybeans, you will usually consider making a cash sale, selling futures, or buying puts. If you are a hog farmer who needs to buy corn and soybean meal, you will be buying cash, buying futures, or buying calls.
I see a huge difference in how farmers approach this depending on age, debt level, and market knowledge. If you look at all of your alternatives and you are aware of the risk of each alternative, then it is easier to make the decision. Those decisions are how much of the crop you want to sell and how you want to sell it.
It is also beneficial to look at the time of year and where you are in the production and marketing cycle for your crop. This is where it is helpful to use the table above.
As Table 2 shows, it takes a very long time for a futures contract to expire. In the last few years, selling futures one or two years ahead of time had been a financial and marketing mistake. Your best marketing selling opportunities have usually occurred the year before you grow the crop, or in the season when you are growing the crop.
Five marketing rules
Back to the young farmer's comment, “I know I need to do something, but I do not want to do the wrong thing.” Here are five rules that will help you do the right thing.
1. Do not panic and sell ahead below your cost of production.
2. Be willing to place hedges on 10% to 20% of your crop – out one or more years in advance – if corn futures rally up $6.50 to $6.90. If prices go up, make additional scale-up sales. If prices turn lower into the next major low, it could be some of your best hedges.
3. Do not pay too much for the put options. If you evaluate the cost of options out 12 to 24 months prior to harvest the put options are way to expensive. Be patient.
4. Choose how much you are selling ahead based on the time of year you are in. After you have made some early hedges, become more aggressive using futures only after you know the federal crop guarantee at the end of February.
5. Use put options in the months when the crop is growing and only if the put option can protect a price that is higher than your crop insurance guarantee.