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Hedges or puts: 4 rules for better decisions
A farmer asked two excellent questions at a marketing seminar last winter. I, along with another instructor, researched the answers. Now they have become part of one of the option classes in the Successful Farming(R) Marketing Academy.
The first question: “What works better: Hedging about 50% of my corn crop at the end of June or buying puts on 100% of the new-crop corn?”
The second question: “When is the best time to put on those hedges?”
Before I dive into the details of the farmer’s two questions, I want to explain the overall three-step risk-management plan that I recommend each year.
- Step 1: Purchase the right revenue crop insurance product for your farm.
- Step 2: Get 60% to 100% of the insured bushels hedged ahead.
- Step 3: Get the rest of your production protected with put options.
Second question first
Regarding the second question, knowing the best time to put on those hedges is difficult. I have sold a lot of corn at planting time, and I have always viewed June 20 to June 23 (the Friday closest to June 22 ) as a key time to make sales. This is also a key change-of-trend time period.
Trend change occurs when markets top out and turn lower, or they bottom out and then rally higher. This tends to be a time of extreme highs or lows, but you are never sure which it will be until you get into that time window.
So how do you use this? If prices rally into that window, it is usually a critical time to get the last of the cash corn and soybeans sold and to place some new-crop hedges for both corn and soybeans. If prices collapse, it is a key time to watch for a low to develop and a great time for livestock feeders to buy corn and soybean meal.
In this slideshow, the long- term corn and soybean charts show that corn prices put in major highs in June of 2008, 2009, 2011, and 2013. You can also see the major lows in 2010 and 2012.
For soybeans, the pattern has been similar but not exactly the same. Major highs came in June of 2008, 2009, and 2013. The soybean market put in major lows in June of 2010 and 2012. In 2011, the market put in a short-term low, rallied until August, and then fell into November.
First question second
Regarding the Iowa farmer’s first question of what works better – hedging about 50% of his corn crop at the end of June or buying puts on 100% of the new-crop corn. The charts on the next page indicate that it depends on the year.
By studying the years it worked best and the years it did not work at all, you can develop some basic rules on when to use hedges on 50% of your crop or puts on 100% of your crop. Unfortunately, there isn’t one master plan that works for every farm.
It’s important to look at what happened in the last six years to new-crop corn prices.
In 2008: Corn prices collapsed from $7.59 to $3.39 in late October. In 2008, you made $4.20 on the hedges and $3.44 on the puts. In this example, you had twice as many puts as hedges, so this year having puts on 100% of your crop outperformed being 50% hedged.
In 2009: You put the hedge on at $4.06, and corn dropped 15¢ to $3.91. You made 15¢ on your hedge, but you lost 25¢ on your put because corn prices did not go down enough to cover the large amount of time premium you purchased. In 2009, the hedges outperformed the puts.
In 2010: You had some margin calls. You placed the December corn hedge at $3.70, and the corn market rallied to $5.38. Your short corn hedge position lost $1.66 per bushel. The put option became worthless, and you lost the 27¢ premium. In 2010, the put outperformed the hedge, because you ended up being able to sell the corn protected with a put at a higher net price level
($5.38 – 0.27 loss on the put = $5.11). This year, the puts outdid the hedges.
In 2011: You placed the hedge in late June at $6.50. Corn prices then dropped to $5.83 by late October. You made 67¢ on the hedge and made 4¢ on the put. The hedges outperformed the puts in this year.
In 2012: You placed the hedge at $5.54 and had some major margin calls. By late October, December corn rallied to $7.46. You had a $1.92 loss on the hedges, and the puts that you paid 43¢ for were worthless. Because of the huge rally in the corn market, you had a higher selling price after losing the 43¢ on the puts. The puts again outperformed the hedges even though the puts became worthless.
In 2013: You placed the hedges at $5.56, and by October, December corn had dropped to $4.40 per bushel. You made $1.16 on the short hedge and 77¢ on the put. Because you had twice as many puts as hedges, the puts outperformed the hedges in 2013.
4 rules to apply
Using the past six years of data, there are four rules that can be applied to build a basic marketing plan.
Putting on new-crop hedges or buying puts when new-crop corn prices are below $4 has not worked. Putting on new-crop hedges or buying puts when corn is over $6.50 has a high probability of working.
If you put on hedges that are above your crop insurance guarantee, it has usually paid to be at least 50% hedged.
The most practical combination over the last six years has usually been to have 50% hedged and at least 50% covered with puts.
If you are in an extreme drought area, using puts is recommended rather than hedges, because you don’t have a delivery commitment.
The bottom line
It may be hard for you to think that puts work better than hedges in the years when you lose money on the puts. Think it through. It is the profit that your farm generates – not your brokerage 1099 – that really counts.
It is ironic that you don’t mind buying crop insurance and never file a claim, but you’re not comfortable losing money on put options in the years when prices move higher. Try to think of puts the same way you think of crop insurance.
Waiting to put on hedges when new-crop corn is $7 is not a realistic expectation in the next few years.
For soybeans, the price pattern has been different than corn. You have two critical change-of-trend time periods. The first is the fourth Friday in June; the second is the week of Thanksgiving. If prices rally, be willing to make sales.