Editor’s Note: Howard Marella was on the front lines of the commodities trading floor at 21 years old. In 2006, he launched Marella Capital Corporation, which later became the futures investment company Icon Alternatives. Here he writes about the importance of a hedging strategy for farmers.
Farmers are all too familiar with the rampant uncertainty that riddles the markets and crops every season. To mitigate risk and help ease the stress associated with it, agriculture professionals should consider putting together a hedging strategy.
Protect Against a Bountiful Harvest
One way hedging makes profits more consistent is by establishing a floor or ceiling for prices, depending on the strategy chosen. When experts are predicting a bountiful harvest, a farmer may want to brace for lower profits due to the expected surplus of crops by locking in profitable prices for the future. If a farmer can profit on soybeans by selling 5,000 bushels at $9.00, then they will want to lock in a future price above that to offset the expected reduction in profits and to lower risk. This gives farmers the opportunity to earn a profit even when they are faced with falling prices.
Protect Against a Poor Harvest
Just as a strong harvest can lower prices, a weak harvest can prove to be detrimental to the profits of a farm. An apt hedging strategy can offset costs regardless of what direction the markets move. An overly humid, dry or wet season can adversely impact the yield of a harvest reducing supply and profits. Not only can the yield be impacted by the hostile weather, but a wet season can cause pests to become unmanageable, further reducing the yield. With so many variables threatening profits, the need to develop and execute a strong hedging strategy is even more important to the health of the farm.
Hedging strategies present opportunities to farms that do not grow their own crops, as the effects of a strong or weak growing season can travel into the cattle industry. Should there be a weak corn harvest, the prices of cornmeal may rise, which will increase the costs of raising cattle. If cattle futures are trading at $2.75 per pound and the rancher can turn a profit at $2.50 per pound, they may want to lock in the price at $2.75 to secure the profit. While there is always a chance the price may increase or decrease, the benefit of hedging is to increase the chance of turning a profit at the end of the season to remain open for the next season.
How it Works
While hedging seems like a complicated process, it is an effective strategy to turn a profit even during challenging times. When establishing a position, it must always balance out the position with an opposite transaction. This means if a farmer buys a futures contract at their first position, then they must offset it later by selling in their second position. The second transaction occurs when the cash market transaction takes place (when the farmer sells their crop), since the hedging price protection is no longer needed and it is closed out.
For example, if a farmer expects their harvest to be at least 20,000 bushels of corn by September, then they can establish a price for the corn in April to protect against the potential of falling prices. In this example, the cash price for corn is $4.50 per bushel in April, and the price of September corn futures is $4.75. The farmer might short hedge his crop by selling four, 5,000-bushel corn futures contracts at $4.75 per bushel. In this example, the price of corn cash and futures falls at the start of August. When the farmer sells their corn to local buyers at $4.22, they may close out their hedge through buying September futures at $4.45. The $0.30 gain in the futures market offsets the lower cash prices allowing the farmer to turn a profit despite the falling prices. Had the farmer not engaged in a hedging strategy, then they would have received $4.22 per bushel earning a loss on the season.
The prices of crops and livestock are in a constant state of flux based on perceived or actual changes in supply or demand. Due to the ever-changing prices, farmers should frequently analyze their risk exposure and adjust their hedging strategies. Whether a farm produces or consumes corn, hedging can minimize risk. (Typically, producers implement a short hedge to lock in prices for their corn. Whereas, consumers employ a long hedge to secure a targeted price.) Creating a tailored hedging strategy is another way for farmers to lock in prices during higher priced periods to reduce risk and uncertainty, as well as secure profits at the end of the season.