Use futures to protect against price fluctuations

How do you weather volatile commodity prices? By managing your risk and protecting your profit margins with futures and hedging. These tools have never been more popular!

A good Corn Belt crop, a politician’s inflammatory remark about free trade, a new virulent strain of swine flu or a long drought that cause grain or pork prices to fluctuate or drive the dollar up or down. You’re not at the mercy of the local market, though; you can also use the futures market to protect against price fluctuations by setting prices and quantities yourself.

Know your costs

Simon Brière is a market strategist at the Montreal office of R.J. O’Brien & Associates Canada, a brokerage firm that has a referral agreement with Desjardins. It’s his job to trade on the Chicago Mercantile Exchange. Before buying or selling futures, he says you need to know the basics: namely your costs so you can develop a better strategy. “When you know how much it costs to produce one ton of corn, you know what price you’ll start to make a profit at. If not, you’ll always be unhappy, either when you sell and the price keeps going up or, when you sell and see that you had the chance to sell even more at that price!”

Unlike speculators who are willing to assume risk, hedgers use futures to avoid risk. How many agricultural producers, grain farmers and speculators are there in the market? Brière say speculators are 20% at most. “While speculation can distort prices, speculators don’t have enough power to affect supply and demand. They’re mostly motivated by profit and aren’t able to influence that dynamic long term. And ultimately, they’re not able to outsmart Mother Nature, which always has the final say in farming!”

Benoit Marcoux, international services expert advisor for Desjardins Business, also warns that futures contracts aren’t casinos. “The people who are most at risk are often those who don’t know how to manage their risk,” he likes to say. Derivatives aren’t investments; they’re tools that are part of a risk management strategy (ideally written down) with measurable objectives. The idea isn’t to passively sell your crop or cattle at a discount, but to play an active role to limit losses or benefit from price increases.

Know prices

Knowing costs and prices is important. There are many apps and websites you can use to track real-time quotes and understand the various risks. The price has three components:

  • Price on the exchange market (Chicago Mercantile Exchange)
  • Exchange rate
  • Basis (difference between the local cash price and the futures market price for a commodity). It reflects local supply and demand for a commodity at a particular place, including transportation costs

Because the basis reflects the actual market, it also corresponds to the proportion of risk that can be covered.

How much of your production should you hedge?

“As with any good portfolio, a marketing plan should spread the risk, so it’s not 0 or 100% of production,” says Brière. “If you’re new to the derivatives market, go slowly, but steadily, and hedge more and more of your production every year.” However, Brière advises against hedging more than 50%. Obviously, every business will be different, depending on their storage capacity. Some will want to spread income over the year, while others can accept huge cash inflows and prolonged shortages. Farms that are in a growth phase, have a lot of debt or have successors will want to manage their risk more carefully, because falling prices can jeopardize their profitability.

What percentage of farmers use hedging?

If it’s 100% of grain centres, it would be between 50 and 60% of grain farmers. Between 5 and 10% of those would even have enough volume and use their own brokerage account to buy and sell futures, says Brière. To participate in this market, you have to produce and trade a minimum of 5,000 bushels of corn (the equivalent of 127 tons). In practice, though, you need at least six times that much, he says.

Why does hedging seem so complicated? “You don’t have to understand all the mechanics,” says Marcoux. “Once you know how much you expect to trade and the price (or rate) you can make a decent margin at, you can set a timeline and start with some simple strategies. But the key to confident trading is getting the right support.” Brière adds, “We expect farmers to understand accounting, agronomy, veterinary medicine, banking—they shouldn’t have to know all about the stock market, too! Good managers surround themselves with experts; that definitely includes a broker who can make trades or offer advice.”