In the final part of our Academy series on managing price risk in the grain markets, the HGCA's Mike Mendelsohn looks at the concept of hedging
Futures contracts were developed to enable participants in a commodity market to protect themselves against adverse price movements through a process called "hedging".
This is the act of using futures or options in equal quantities to your physical grain, to lock in either a fixed price or a minimum price. For a grower in possession of physical grain, hedging by selling futures contracts guarantees the value of forward sales by "locking in" a futures price.
Hedging using futures
Suppose in February, a grower expects his wheat crop to yield about 1000t after harvest. He decides to commit 1000t of November futures at £95/t to "hedge" against the risk of a price drop on the physical grain he has not yet sold ie, he "locks in" a price for his wheat at £92/t for November delivery (futures price of £95/t, less £3/t "basis" - the relationship between futures, delivered and ex-farm prices).
Let us assume that it in October the physical price for wheat falls to £82/t. The grower now sells 1000t of physical wheat. At the same time as selling the 1000t of physical wheat, the grower buys 1000t of futures contracts to offset the 1000t futures position he still has open. As the futures and physical market prices tend to move in the same direction, the futures price has fallen to £85/t. The farmer makes £10/t profit on the futures contract.
So for 1t of wheat, our farmer has gained £82/t on the physical market, plus £10/t on the futures market, equating to £92/t - the price he effectively fixed in February.
The market has dropped by £10/t and the futures price has also fallen by the same amount. But the "hedge" has allowed the grower to still realise a price of £92/t rather than the £82/t he would have had to have taken if he had not hedged.
But if the futures market had risen to £105/t, the grower would sell his physical grain for £102/t. But he would then have to buy back the futures (which he sold at £95/t) for £105/t, so his net gain would be £102/t. Because he would have lost £10/t on the future market, his net gain would be £92/t, the same price as above.
Think of the option premium as an insurance premium.
If you insure your car for a year it will cost more than
insuring it for a month - the same applies with an option
Hedging using "Put" option
Let us reconsider the example above. Suppose the farmer decides, in February, that he wishes to protect against a fall in the wheat price for the 1000t of physical wheat he has yet to sell.
But, similarly, he is anxious to benefit from any price rallies that could occur. He buys "Put" options (which give him the right, but not the obligation, to sell 1000t of wheat futures for November delivery) at £95/t, paying a £5/t premium for his "insurance" against a fall in price.
The minimum price he can now receive for his wheat is £95/t, less £3/t basis, less £5/t option premium - £87/t. If the physical market price falls to £85/t, the overall price the grower will receive remains £87/t.
Though this is less than the grower would have obtained by hedging with a futures contract, he can still take advantage of any rise in the market price by letting his option expire and selling his wheat on the physical market for more money.
If, for example, the physical market rises to £102/t, the grower abandons his Put option and sells his physical wheat for £102/t. He gains £102/t on the physical market less £5/t for the option premium, leaving him to pocket £97/t. This compares with the £92/t he would have received had the grower hedged with futures.
Buying a Put option enables the grower to benefit from an upward movement while minimising the risk of any downward movement in price.
Hedging example using "Call" option
Options can also enable a grower to benefit from an increase in market prices even though he has already sold his physical grain.
Suppose that the grower has sold his 1000t of physical grain forward for November delivery at £92/t. However he would like to be able to benefit from any futures price rise, so he buys 1000t of November Call options at £95/t, paying a premium of £5/t, as in the example above.
If the price of the futures contract rises to £105/t, the grower will exercise his right to buy futures contracts at £95/t, and then offset these immediately by selling them at the current price of £105/t. Although the grower has already sold his physical grain, he is still able to benefit from upside market movement, and earns an additional £5/t from purchasing the Call options (£10/t futures gain, less £5/t option premium).
Options pricing
There are three elements that influence the notional value of a premium.
- The price of the underlying futures contract, together with the option's exercise or strike price.
- Time to expiry, since the longer the option remains valid, the more opportunity there is for the underlying futures market to move substantially.
- Volatility of the underlying futures contract. Higher volatility means risks for option sellers are greater.
It is useful to think of the option premium as an insurance premium. If you insure your car for a year it will cost more than insuring it for a month - the same applies with an option. If the car is fast it will be considered to be higher risk, and the premium will be higher - the same applies with options.
Some practicalities
Before trading futures or options you need to open an account with a registered broker. It is also necessary to lodge a cash deposit. This is known as an initial margin, and is used to cover variations in the value of your position. Futures positions are settled daily, so if the market moves in your favour your account will be credited. If the market moves against you, a deduction will be immediately made from your deposit. If the fall is greater than the deposit, you will be issued with a "margin call", and are required to provide the difference immediately. In this way the clearing house can ensure that there is no risk to either party in the futures and options markets.