This is an ultra-variable world where global climate cycles create long-term & short-term trends that can result in global changes in production and prices of crop products that are hard to predict. Local weather events also impact these and can devastate the pricing of production and of markets alike. Simply put, long-term price changes in global crop prices are up to a significant extent driven by changes in trade policies, which offer an ideal and efficient way to hedge through the futures and options market, if one believes that these markets are efficient and guarantee reasonably high chances of profitability. Let’s understand hedging in agricultural commodities using futures and options as risk management instruments.
A futures contract, in simplest terms, is an agreement that a certain number of commodities will be sold or bought at a set price at a future time. In contrast, options allow you to buy/sell a commodity at an agreed-upon price on or before the date the contract expires.
What Exactly is involved in the hedging process?
Establishing the Hedge Position: It is the starting point in the hedging cycle where you start playing in the future market to have a fair idea in the coming year what commodities should be produced/released based on the demand & supply as the top predictor protecting farmers from the adverse price movements in the cash market of the commodity.
Managing Price Fluctuations: This type of hedging strategy is only effective when it comes to price risk management. Meanwhile, if the market price falls below the futures price that the farmer has already locked in, the farmer can sell the futures contract for more than they would get if they allowed it to expire, preventing additional income losses. Conversely, if the market price went above and beyond the locked-in futures price, the farmer would have forgone some of the profits from the sale of his physical crop, yet he would enjoy the benefit of supplementation of a higher price due to futures options trading for the selling price.
Lifting the Hedge: Converting the notional gain or loss on paper in the futures market to realized profit or loss upon the sale of the physical commodity, the next logical step in the hedging process, especially for farmers and agribusinesses, is to settle the futures contracts to cash upon the delivery of the underlying commodity into the cash market.
Such contracts are binding and can help hedge future risks, however, they become highly risky due to the commitment involved for the future. In contrast, options contracts allow the buyer to act unrestrictedly, allowing the trader to combine a reduced-risk approach to trading and speculation. That distinction affects how traders and investors alike utilize these financial instruments as salient tweaks to their risk tolerance and investment thesis.