Following is an email I received from a member of the group raising several questions about how to handle some real time price risk management challenges. As I have noted on the discussion page earlier, I think this is an excellent opportunity for all of us to learn from the experience.
—– Original Message —–
Sent: Thursday, June 13, 201310:12 AM
OK – here’s a new twist to my dilemma. I sold a contract of beans at $12.12 two months ago. Price today is $13.00. I didn’t lift the hedge as the trend indicator showed an upward trend. The market has moved so far away from me that lifting it now would be costly and maybe not gain me anything. My insurance guarantee is $12.88 (spring price) as a floor. The upside is still open since I took harvest price option so if price is higher than $12.88 at harvest, they will pay me the difference at harvest. I will miss price spikes above that between now and then if the price drops at harvest but spikes now on weather.
Should I try to mitigate my earlier mistake by selling new contracts on the Board at $13.00 to counter my earlier futures sales at$12.88 and not worry about losing any more upside in price movement or should I monitor the 5-35 MA to see when to lift or re-hedge? Do I do something to reverse my mistake or is my only option to watch indicators and hope price drops to $12.12 so I can lift my hedge? Are options the answer?
In reality, there are several questions which overlap and help to create confusion. Taken one at a time, I think we can make some progress. Let’s start with 5,000 bushels of soybeans insured at $12.88. The insurance is revenue guarantee so it covers both price and yield risk. This provides a floor under revenue much like a Call option under price. The level of insurance is at 85% so that it an effective guarantee for the whole crop of $10.95. Assuming that the $10.95 covers cost of production, no further action is necessary if price protection to cover the cost of production is the only goal. But if cost of production is higher than $10.95 or maximizing net realized price is also a part of the marketing objective, then several new issues are on the table.
Now let’s address the futures contract that was sold at $12.12 and has an $0.88 loss because the contract is now trading at $13.00. If you were speculating, this would be a fairly serious situation. It is still serious but far less so if you combine the futures contract with the 5,000 bushels of beans that are anticipated for delivery later. In the extreme, the 5,000 bushels of beans could be delivered to satisfy the futures contract, in which case the beans were simply sold for $12.12 less basis. You don’t have to buy back the contract at $13.00, so the $0.88 loss in the hedging account goes away. Margin money will be required to hold the position until delivery, but it will be returned when the futures contract is satisfied.
What else can we do with the futures contract? There are many choices but we need to stay as close to the marketing plan as possible. This sale was meant to be a true hedge, except that the futures contract was to be bought back when a cash delivery was made. A close cousin would be to lift the futures contract at any time and replace it with a cash contract. In both cases, there would be a loss in the hedging account but the increase in the cash value of the beans since the $12.12 sale will ultimately offset the loss in the hedging account. Therefore, dealing with the futures contract as a part of a true hedge is a matter of personal preference for when the futures contract is replaced by a cash sale or cash forward contract. There is a time cost for the margin money necessary to maintain the hedging account, but otherwise the two transactions should be a wash.
Now, if the goal is to cover a higher cost of production or to maximize net realized price, the dilemma becomes much more complicated and challenging. This would shift the focus clearly to the price trend and anticipated future prices. In one sense, the $0.88 loss on the futures contract should be ignored. There is little that can be done to change the situation which gave rise to the $0.88 loss. If you are trying to maximize net realized price, then there is only one decision that has to be made in order to decide if the futures contract should be held or bought back. That decision is whether it is reasonable to expect that it will be possible to sell the beans again later for a price higher than the current $13.00. If not, you can not improve the position by buying back the contract, except to stop the costs of maintaining the margin account. If it is reasonable to expect that the beans can be sold later for a price above the $13.00, then the $0.88 lost that has already been incurred can be reduced. The gain on the subsequent sale will help to reduce the loss in the trading account.
Let there be no confusion, reasonable expectation must be supported by a very clear and reliable method of anticipating future prices. I am careful not to say projected future prices because that is simply a matter of making some assumptions about the future which may or may not reflect reality. Certainly the 2012 drought created realistic expectations of lower yields and did lead to projected prices with a solid basis for the projection. For the most part, the kind of information which would lead to reasonable adjustments in price expectations is going to involve expectations of production adjustments downward. I haven’t seen that kind of fundamental information at this time. It may be forth coming, but I don’t have a sense that we have production information that is reliable enough to anticipate or project a continued price rally. The main point about the $0.88 loss in the hedging account is that it should not drive the decision to hold or lift the futures contract. That decision should be based primarily on whether the beans can be sold later for a higher price.
The other alternative is that we have to turn to the charts and a trend tracking system that tells us if the market is going higher. There is no magic in deciding which technical indicator is the most reliable at telling us if the trend is up or down. It is simply a matter of reviewing historical charts with various indicators and finding the indicator which has been the most consistent and reliable. With the right software package and data set, it would be possible to back test previous charts to determine precisely which indicator produced the highest net realized price over time. So far in this discussion group, we have only limited tools in the technical analysis toolbox. We have discussed and monitored a moving average crossover using 5 and 35 day averages. MA(5) crossed up through MA(35) on May 20 to signal a short term rally. MA(35) is the dominant trend indicator in this system, and it has clearly turned up.
We have reached a major decision point for me. That is whether to restrict my analysis of the dilemma to the methods some of the beginners have been trying to learn, or whether to make use of some of the other tools I have in my toolbox to create a context for my answers to the specific questions. The danger is that I feed the fears that technical analysis is too complicated. Some of my other tools help explain why I am more confident in the MA(5,35) system indicating that the trend is up. But please understand that some of these other tools are considered “soft” in that they do not have the quantitative characteristics of an indicator like moving averages.
I use Elliott Wave analysis as an overall picture of what is happening. This indicator, in combination with Fibonacci numbers, is projecting that the price will correct down into the 1290 to 1260 range, and then continue the rally to 1400 and beyond. A proprietary power indicator projects that the market will make a new high above the 1331 high made recently. Another calculation of the retracement projects that one of the likely areas for the correction is into the 1287-1276 range. Other technicians make a point of looking for corrections to fill gaps such as the one between 1252 and 1263. Look closely at MA(35). For the next few day the values removed from the averages are going to be from the low prices back in late April. That is to say that if the current prices stay any where near the current levels, MA(35) will continue to rally. Price and MA(5) are well above MA(35), meaning that a confirmed correction is not imminent in the next few days. None of these should be taken as quantitative projections, but simply as interpretations of various indicators on the chart.
Now to the questions. Should I sell new contracts at $13.00 ….? While selling additional contracts would average the price of sales up, I discourage this line of discussion because it would be doubling up, or selling the same bushels more than once. That is speculating. Now, if you want to add to total sales at the $13.00 level, that is a new contract with new issues, but don’t confuse it with trying to deal with the previous sale. If my assessment of the direction of the market is correct, it seems likely that you would soon find yourself with additional losses on the new contract as well. If we do move into the $14.00 range, and the trend changes, then selling additional bushels may be attractive on its own merits, but not as a way to correct for a previous sale.
Should I try to mitigate …? You could lift the futures contract and replace it with a cash contract if you want to avoid further margin calls, but you will most likely be giving away any opportunity to take advantage of a market rally because it is difficult to lift a cash contract. You could buy a Call option to protect against some of future loss in the hedging account, but again this is doubling up so I discourage it. You could sell a Call option to raise cash, but this is clearly a form of speculation that can have unlimited risk. This is an action that should only be pursued if you are in position to monitor the market very closely. You could just buy back the contract and absorb the current loss in the hedging account in hopes the price will continue to rally so the cash sales will make up for some of the hedging loss. There are many actions that would mitigate the current situation, but be careful consider whether any proposed action is part of a price risk management strategy or just speculating to try to earn back the loss on a previous sale.
Monitor the MA(5,35) system to decide when to lift the futures contract and to place the hedge again ….? Certainly this is in keeping with the overall focus of the website and learning process. I have a couple of reservations. It is unlikely the MA(5,35) system will pick up the path of a relatively small and short term correction into the 1290-1260 range. Likewise, I am not sure that MA(5,35) will signal the continuation of the rally in a timely manner in order to lift the futures contract. MA(35) is suggested for selective hedging because it is better at avoiding short term market corrections and only picking up longer term trend changes. Given that I would be looking for a change of short term trend within a specific price range, I would use the price crossing MA(35) as a signal instead of waiting for MA(5) to cross. And yes, I would look to the MA(5,35) system for a signal of trend change at the top of the rally.
Do I do something ….? That is a personal call. In principal I would encourage you to just treat the 5,000 bushels as a hedged sale. If you follow that strategy, then I might consider lifting the futures contract and replacing it with a cash contract for delivery. Keep in mind that before you began to study selective hedging and trend analysis, you would probably have put a cash contract on the books at the $12.12 equivalent and have never had second thoughts about any possible changes. Don’t try to do too much.
Or ….hope price drops to $12.12 so I can lift the hedge? I hope not because that would mean that your cash position had lost substantial value with a drop from the current levels. Try to separate any decision you make from the fact that the contract was sold at $12.12. Very difficult, but it is one of the emotions you have to be able to control or it will be impossible to rational when it is time to make the next decision.
Are options the answer? Certainly option contracts could be used in several ways, but I don’t see any obvious advantages if the main focus is still to maximize net realized price while managing price risk. Cash or futures contracts tend to result in higher net realized prices than option contracts when the trend is correctly assessed because of the option premiums. Option contracts work best when the trend is not clearly defined or assessed.
There is a lot of material here to digest, and lots of room for other opinions or approaches to the dilemma. In the end, many of the choices are personal preference rather than clear right or wrong attempts to deal with the dilemma.
Questions and comments are encouraged with a Reply to the associated discussion email or using the Contact Us page of the website.
Posted by Keith D. Rogers on 17 June 2013.