Hedging Against Falling Corn Prices using Corn Futures

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Contents

Hedging Against Falling Corn Prices using Corn Futures

Corn producers can hedge against falling corn price by taking up a position in the corn futures market.

Corn producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of corn that is only ready for sale sometime in the future.

To implement the short hedge, corn producers sell (short) enough corn futures contracts in the futures market to cover the quantity of corn to be produced.

Corn Futures Short Hedge Example

A corn grower has just entered into a contract to sell 5,000 tonnes of corn, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of corn on the day of delivery. At the time of signing the agreement, spot price for corn is EUR 129.25/ton while the price of corn futures for delivery in 3 months’ time is EUR 130.00/ton.

To lock in the selling price at EUR 130.00/ton, the corn grower can enter a short position in an appropriate number of Euronext Corn futures contracts. With each Euronext Corn futures contract covering 50 tonnes of corn, the corn grower will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the corn grower will be able to sell the 5,000 tonnes of corn at EUR 130.00/ton for a total amount of EUR 650,000. Let’s see how this is achieved by looking at scenarios in which the price of corn makes a significant move either upwards or downwards by delivery date.

Scenario #1: Corn Spot Price Fell by 10% to EUR 116.33/ton on Delivery Date

As per the sales contract, the corn grower will have to sell the corn at only EUR 116.33/ton, resulting in a net sales proceeds of EUR 581,625.

By delivery date, the corn futures price will have converged with the corn spot price and will be equal to EUR 116.33/ton. As the short futures position was entered at EUR 130.00/ton, it will have gained EUR 130.00 – EUR 116.33 = EUR 13.68 per tonne. With 100 contracts covering a total of 5000 tonnes, the total gain from the short futures position is EUR 68,375

Together, the gain in the corn futures market and the amount realised from the sales contract will total EUR 68,375 + EUR 581,625 = EUR 650,000. This amount is equivalent to selling 5,000 tonnes of corn at EUR 130.00/ton.

Scenario #2: Corn Spot Price Rose by 10% to EUR 142.18/ton on Delivery Date

With the increase in corn price to EUR 142.18/ton, the corn producer will be able to sell the 5,000 tonnes of corn for a higher net sales proceeds of EUR 710,875.

However, as the short futures position was entered at a lower price of EUR 130.00/ton, it will have lost EUR 142.18 – EUR 130.00 = EUR 12.18 per tonne. With 100 contracts covering a total of 5,000 tonnes of corn, the total loss from the short futures position is EUR 60,875.

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In the end, the higher sales proceeds is offset by the loss in the corn futures market, resulting in a net proceeds of EUR 710,875 – EUR 60,875 = EUR 650,000. Again, this is the same amount that would be received by selling 5,000 tonnes of corn at EUR 130.00/ton.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the corn seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling corn prices while still be able to benefit from a rise in corn price is to buy corn put options.

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In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

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Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Hedging Against Rising Corn Prices using Corn Futures

Businesses that need to buy significant quantities of corn can hedge against rising corn price by taking up a position in the corn futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of corn that they will require sometime in the future.

To implement the long hedge, enough corn futures are to be purchased to cover the quantity of corn required by the business operator.

Corn Futures Long Hedge Example

An ethanol producer will need to procure 5,000 tonnes of corn in 3 months’ time. The prevailing spot price for corn is EUR 129.25/ton while the price of corn futures for delivery in 3 months’ time is EUR 130.00/ton. To hedge against a rise in corn price, the ethanol producer decided to lock in a future purchase price of EUR 130.00/ton by taking a long position in an appropriate number of Euronext Corn futures contracts. With each Euronext Corn futures contract covering 50 tonnes of corn, the ethanol producer will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the ethanol producer will be able to purchase the 5,000 tonnes of corn at EUR 130.00/ton for a total amount of EUR 650,000. Let’s see how this is achieved by looking at scenarios in which the price of corn makes a significant move either upwards or downwards by delivery date.

Scenario #1: Corn Spot Price Rose by 10% to EUR 142.18/ton on Delivery Date

With the increase in corn price to EUR 142.18/ton, the ethanol producer will now have to pay EUR 710,875 for the 5,000 tonnes of corn. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the corn futures price will have converged with the corn spot price and will be equal to EUR 142.18/ton. As the long futures position was entered at a lower price of EUR 130.00/ton, it will have gained EUR 142.18 – EUR 130.00 = EUR 12.18 per tonne. With 100 contracts covering a total of 5,000 tonnes of corn, the total gain from the long futures position is EUR 60,875.

In the end, the higher purchase price is offset by the gain in the corn futures market, resulting in a net payment amount of EUR 710,875 – EUR 60,875 = EUR 650,000. This amount is equivalent to the amount payable when buying the 5,000 tonnes of corn at EUR 130.00/ton.

Scenario #2: Corn Spot Price Fell by 10% to EUR 116.33/ton on Delivery Date

With the spot price having fallen to EUR 116.33/ton, the ethanol producer will only need to pay EUR 581,625 for the corn. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the corn futures price will have converged with the corn spot price and will be equal to EUR 116.33/ton. As the long futures position was entered at EUR 130.00/ton, it will have lost EUR 130.00 – EUR 116.33 = EUR 13.68 per tonne. With 100 contracts covering a total of 5,000 tonnes, the total loss from the long futures position is EUR 68,375

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the corn futures market and the net amount payable will be EUR 581,625 + EUR 68,375 = EUR 650,000. Once again, this amount is equivalent to buying 5,000 tonnes of corn at EUR 130.00/ton.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the corn buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising corn prices while still be able to benefit from a fall in corn price is to buy corn call options.

Learn More About Corn Futures & Options Trading

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

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Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

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3 Hedging Techniques Using Futures

April 8, 2020 by Daniels Trading | Futures 101

In the business world, “risk” is often the nastiest four-letter word in the book. As a result, finding effective hedging techniques to protect asset values and profitability is a common pursuit for people in a wide variety of industries.

Due to their inherent flexibility, futures products are especially useful for hedging. The applications of futures in risk management are extensive, limited only by the imagination of the individual. Regardless of your position in the market or business world, futures hedging techniques can help you limit risks — both foreseeable and obscure.

Three Futures Hedging Techniques

When it comes right down to it, if you’re interested in hedging you’re either a consumer, producer, or investor. It’s important to remember that each of these roles is not mutually exclusive of the others and that all feature a collection of unique risks. Futures can be a great help when addressing your exposure, regardless of perspective.

#1 Producer Hedging

Of all of the futures hedging techniques examined in this article, those used to address producer risk are the most intuitive. Farmers and ranchers frequently implement strategies designed to mitigate the negative impacts of harsh weather or global geopolitics on asset pricing. This is a common practice among commodities producers for good reason ― an untimely market fundamental can destroy a year’s worth of work.

Managing the risk facing an upcoming delivery to market may be accomplished in many ways. One simple strategy using futures is to take an offsetting short position in the commodity to be delivered. For example, assume that Iowa corn farmer Morgan is anxious over the prospects of an industry-wide bumper crop swamping the markets with supply. To insulate against falling corn prices come harvest time in October, Morgan turns to the futures markets:

  • Given a yield of 130 bushels per acre, Morgan sells 13 September corn futures contracts (ZC) for every 500 planted acres. The position is taken shortly after planting in mid-April.

If the corn market weakens as Morgan predicts, losses in the cash markets are offset by gains realized from the short futures position.

#2 Consumer Hedging

From the standpoint of the consumer, risk is assigned according to the pending acquisition of assets. If you’re planning to purchase the raw materials you need to conduct business, then the pricing of those items is of paramount importance. Many businesses, both large and small, typically use futures hedging techniques within the framework of a comprehensive risk management plan.

For instance, let’s assume that Hayden Wire Inc. is in search of protection from a late-year spike in metals pricing. Rising copper prices may force a scaling-back of production and crush the company’s profitability for the coming year. The futures markets can help Hayden limit risk via the following strategy:

  • Hayden Inc. purchases 20 December copper futures contracts (HG) to cover exposure to the 500,000 pounds of raw copper needed for the coming quarter’s workload.

In the event prices spike, the added cost to secure the needed copper is largely offset by gains realized from the long futures position. If prices fall, losses from the long position are mitigated by the affordability of the physical asset.

#3 Investor Hedging

While the hedging techniques for producers and consumers involve straightforward buying and selling, managing investment risk is a more nuanced subject. One basic way that futures are used to hedge investment risk is in the arena of equities. As an example, assume that Avery the stock picker anticipates a U.S. equities bull market developing during the coming summer months. Subsequently, Avery takes a large long position in the S&P 500 to capitalize on the action. Futures can be used as protection against negative market drivers in the following manner:

  • Avery sells 15 September E-mini S&P 500 futures contracts to limit portfolio exposure to any detrimental swings in seasonal equities pricing.

If an unforeseen event occurs that drives the value of U.S. stocks lower, Avery’s long position in the S&P 500 is protected. Gains will be realized from the short position in the E-mini S&P 500, at least minimizing the damage sustained by the outstanding cash position.

Avoid Catastrophe with Hedging

Although the strategies outlined in this blog certainly reduce risk exposure, there’s no perfect hedge. A risk of loss is involved in every facet of finance ― hedging is simply a way to put it into acceptable terms.

For more information on how to hedge your crop, business, or portfolio, schedule a no-obligation conversation with the pros at Daniels Trading today.

About Daniels Trading

Daniels Trading is an independent futures brokerage firm located in the heart of Chicago’s financial district. Established by renowned commodity trader Andy Daniels in 1995, Daniels Trading is built on a culture of trust committed to the firm’s mission of Independence, Objectivity and Reliability.

Risk Disclosure

This material is conveyed as a solicitation for entering into a derivatives transaction.

This material has been prepared by a Daniels Trading broker who provides research market commentary and trade recommendations as part of his or her solicitation for accounts and solicitation for trades; however, Daniels Trading does not maintain a research department as defined in CFTC Rule 1.71. Daniels Trading, its principals, brokers and employees may trade in derivatives for their own accounts or for the accounts of others. Due to various factors (such as risk tolerance, margin requirements, trading objectives, short term vs. long term strategies, technical vs. fundamental market analysis, and other factors) such trading may result in the initiation or liquidation of positions that are different from or contrary to the opinions and recommendations contained therein.

Past performance is not necessarily indicative of future performance. The risk of loss in trading futures contracts or commodity options can be substantial, and therefore investors should understand the risks involved in taking leveraged positions and must assume responsibility for the risks associated with such investments and for their results.

Trade recommendations and profit/loss calculations may not include commissions and fees. Please consult your broker for details based on your trading arrangement and commission setup.

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