When first introduced to the idea of hedging with future contracts, it can be intimidating to say the least. The jargon of trading, images of Wall street, and complex trading practices come to mind that a farmer with a crop of corn or wheat might never have imagined any involvement with. These images are not what hedging is about, however. Hedging can be reduced to several very basic steps, and once understood it can be a tool that offers great benefit to farmers. At its very best, a farmer who can use hedging in an effective way reduces the risk of losing money if the value of his or her crops fall.
Futures
As mentioned above, the purpose a farmer might have for the of buying of selling a futures …show more content…
As specified contract delivery date approaches, a farmer will instead buy as the same amount of contracts as they had originally agreed to sell. This is called “offsetting”. Selling these contracts before the harvest date allowed the farmer to pick a price level for their crop that they found acceptable.
Since contracts are generally not sold to the facilitating market, this means most hedgers must pay for the price of the of buying the contracts that they had originally agreed to sell. In this way, the Hedging farmer may lose or gain money as the price of his or her crop may be higher or lower than when the Future contract was first sold. The advantage that the hedging process provides, is that the price of the futures contracts is correlated with the cash price to such a degree that the cash prices in the future can be projected once the use of the basis is incorporated into an …show more content…
Hedgers must maintain margin accounts of considerable sizes and the small seeming incremental changes in prices can effect even smaller hedgers on the scale of thousands of dollars.
Analysis on the Ratio to Hedge Depending on the amount that a farmer is producing, hedging can have considerable benefits. Determining the proportion to hedge and the portion to allow to fluctuate along with spot prices is a task that involves some projections and forecasting. A rule-of-thumb for crop hedging has been to hedge 80% of the total crop and allow 20% to fluctuate with prices. Analysis in New Mexico State University’s AEEC 511 has indicated that this ratio would be closer to optimal be at 67% contracted crops, meaning that famers going short in the futures market should aim to have 67% of their total crops sold ahead of time.
This number comes from the recorded market fluctuations over the past eight years of wheat futures, spot prices and basis changes. Like all forecasts, this number is subject to some error, but is likely close enough to be useful for many farmers within the state to