HEDGING STRATEGY YIELDS $7.53 AVERAGE

Executive Summary:  A combined system of pre-harvest strategy (CZ contracts) with a post-harvest strategy (CN contracts) would have delivered an average price of $7.53 per bushel for the last six years.  That price is $2.04 over the average price for the period and in the top FIVE PERCENT of the combined PRICE RANGE for the December and July contracts.  In four of the six years, the effective price exceeded the highest price offered on either of the two contracts.  Clearly, success and your future depend on knowing when to hold and when to sell.  Finding the competitive edge will make a huge difference.  

By Keith D. Rogers

Growth of your business in this price environment will depend on fine tuning every aspect of your system.  Effective marketing is just one aspect, of course, but it may offer one of the largest returns on investment that you can achieve. Track records for traditional approaches to price risk management indicate that those strategies are unlikely to deliver the prices needed to cover production costs and survival, and certainly are unlikely to generate the necessary capital needed to grow the business.  Many marketing and price risk management systems are offered, but few approach the level of performance described in this article.

The challenges and opportunities offered by the market volatility are well known.  The CZ12 chart below is an updated version of a chart from Hedging Works: Myth or Reality? where those opportunities were discussed in detail.  It demonstrates the potential for using volatility to maximize price while managing price risk.  The system is based on placing and removing selective hedges at strategic points.  While the results are impressive, the author is quick to acknowledge that the results depend on a theoretical argument about finding a reliable system to identify and signal the critical turning points.  There is no claim that the system exists, but the discussion brings the potential into focus.  For aggressive managers, knowing what is possible is the first step to deciding what is a realistic target or goal.

This article moves from a theoretical discussion of what could be to a review of actual results from a study based on signals developed from proprietary quantitative systems that can be reproduced and backtested.  Studies reported in the Hedging book were based on the last five completed marketing years when the original manuscript was being produced.  By default, those base years have become a reference point for additional studies. 

This study looks at the effectiveness of combining a pre-harvest strategy (CZ contracts) with a post-harvest strategy (CN contracts) to extend the window for price risk management and marketing.  The analysis is based on the last 600 days of each contract, for a total of 1,200 days monitored for each marketing year.  It should be recognized and acknowledged that there is overlap between the 600 days of the July contracts and parts of the December contracts.  For a less aggressive strategy, some producers may prefer to monitor a shorter period for harvest delivery dates, and not allow for overlap between the Dec and July contracts.  Obviously, that will change the outcome, but the focus here is on what is possible, in real time with real signals.

The average for the December contracts (six years including 2008/09-2013/14) was $5.03 with an average range of $3.58 to $7.35.  The average for the July contracts was $5.39 with an average range of $3.93 to $7.67.  The average close for the Dec contracts was $5.08, and for the July contract it was $5.48.

Perhaps the first observation is that there was an average carry of $0.40 from the Dec close to the July close that would help explain the proliferation of on-farm storage and traditional strategies to sell gain out of storage.  However, it should be noted that ALL of the storage gain came in two of the six years.  In the other four years, Dec close was higher than July close.  Clearly, the key to maximizing this strategy, price, and profit is knowing which two years out of the six would benefit from storage.  Since none of us have a crystal ball, capturing the benefit depends on having a system to signal if or when the trend is up.

The technical indicators used for this study are based on standard moving averages which have been modified to minimize false signals and unnecessary trading.  Different indicators and parameters could be chosen, depending on the producer’s bias or preference, for a strategy that would work better for a system based on forward cash sales or for a system based on futures and options sales.

The average July close was $5.48.  The average hedging gain brought forward from the Dec contract was $1.16, and the average hedging gain for the July contract was $0.89.  Combining the closing price with the hedging gains that were banked along the way, the net price was $7.53. 

As points of reference, average closing price of $5.48 was in the bottom 45% of the total price range for the Dec and July contracts.  The overall average price for all days was $5.21, putting it in the bottom 42% the total price range.  Finally, the selective hedging price of $7.53 was in the top 95% of the total price range.  The four years that the selective hedging price exceeded the highest price in the range, the average was 110% of the price range. 

You can’t pick market highs and lows, but you can determine strategic entry and exit points, based on quantitative technical indicators.

Posted:  25 January 2015