New December 2000
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This guide describes how to place an output (short) hedge in the futures market to reduce the price risk associated with selling an output used in your business. For example, assume that John, a cattle producer, knows he will be selling a pen of cattle two months from now. John knows that by selling live cattle for over $62 per hundredweight, he can ensure a satisfactory profit. Currently, the local live cattle price is $64 per hundredweight, but John believes that the price may drop during the next few months. By knowing the cost of production of these animals, John knows that $64 per hundredweightwill allow for a satisfactory profit. What can he do to reduce his risk from a potential drop in prices? John cannot sell the cattle now because the cattle are too light, but he could enter the futures market and offset any loss in value (decrease in price) with a gain in the futures market.
Placing a hedge can be a simple process. First, knowing your cost of production helps you know when to place a hedge. To place a hedge, you need to contact a broker with whom you place an order. Most large communities have a broker who will take your order for a set fee (as is common when placing any futures market order). The broker can be helpful in informing you on how to place and exit your hedging position. The broker has a stake -- a commission -- in
making sure your experience with hedging using futures is a good one. After
you have placed the order, the broker will contact a brokerage house at the
commodity exchange and relay the order. On the trading floor of the trading
commission, market supply and demand forces are matched so that if you want
to place a short hedge, there will always be either someone wanting to place
a long hedge or a speculator willing to offset your risk. This process is known
as arbitrage and is discussed in more detail in an accompanying risk management
guide in this series
Any of seven scenarios can arise between the cash and futures price. The only common scenario not discussed below is that of the cash and futures prices not changing while the hedge is placed. In this scenario, the producer sells the output for the same price as when the hedge was placed. The costs of hedging would then simply be commissions. The other scenarios are discussed below. Because the cash and futures markets typically trend in the same direction, the scenario of the two markets moving in opposite directions is not discussed.
Cash price decreases faster than the futures price
In this scenario, basis is said to weaken. Using Table 1, suppose you could sell live cattle today for $64 per hundredweight and the relevant futures contract is trading for $65 per hundredweight (basis is $1 under). Knowing that you will sell cattle at a later date and you want to protect against a price decrease, you take a short position in the futures market at this time. Over the next few months the local cash price decreases to $60 per hundredweight and the futures price decreases to $63 per hundredweight. At this time you decide the cattle need to go to market. You sell cattle in the cash market for $60 per hundredweight and buy back your futures position for $63 per hundredweight. Therefore, the revenue from selling cattle is $60 per hundredweight plus $2 per hundredweight gain from the futures position less any commission costs (a typical commission might be $30 for entry into the futures and $30 for exit, $60 per round-turn or about $0.15 per hundredweight). Instead of selling for $60 per hundredweight, you sell for $61.85 per hundredweight. The net price you receive is exactly equal to the original cash price plus the basis gain or loss, less commission.
Futures price decreases more than the cash price
In this scenario, basis is said to strengthen. Again, suppose you could
sell live cattle today for $64 per hundredweight and the relevant futures contract is trading
for $65 per hundredweight (basis is $1 under). Knowing that you will sell cattle at a later
date and you want to protect against a price decrease, you take a short position
in the futures market at this time. Over the next few months, the local cash
price decreases to $60 per hundredweight and the futures price decreases to $60 per hundredweight (Table
2). At this time you decide the cattle need to go to market. You sell cattle
in the cash market for $60 per hundredweight and buy back your futures position for $60 per hundredweight.
Therefore, the revenue from selling cattle is $60 per hundredweight plus $5 per hundredweight gain from the
futures position less any commission costs. Instead of selling for $60 per hundredweight, you
sell for $64.85 per hundredweight. The net price you receive is equal to the original cash
price plus the basis gain or loss less commission.
Futures price decreases at the same rate as the cash price
In this scenario the price you receive equals the price you would have received earlier with the exception of commissions ($0.15 per hundredweight). There is no basis change here and the net price is equal to the original cash price less commission.
Table 1
Short hedge with futures as cash price decreases.
| Cash price decreases more than futures price | |||
|---|---|---|---|
| Cash | Futures | Basis | |
| Today $64 per hundredweight |
Sell live cattle contract at $65 per hundredweight | -$1 per hundredweight (under) | |
| Later Sell cattle in local market at $60 per hundredweight |
Buy live cattle contract back at $63 per hundredweight | -$3 per hundredweight (under) | |
| Results | Selling price | $60 per hundredweight | -$2 basis loss |
| Less commission | $0.15 per hundredweight | ||
| Plus futures gain | $2 per hundredweight | ||
| Net selling price | $61.85 per hundredweight | ||
Table 2
Short hedge with futures as cash price decreases.
| Futures price decreases faster than cash price | |||
|---|---|---|---|
| Cash | Futures | Basis | |
| Today $64 per hundredweight |
Sell live cattle contract at $65 per hundredweight | -$1 per hundredweight (under) | |
| Later Sell cattle in local market at $60 per hundredweight |
Buy live cattle contract back at $60 per hundredweight | -$0 per hundredweight | |
| Results | Selling price | $60 per hundredweight | $1 basis gain |
| Less commission | $0.15 per hundredweight | ||
| Plus futures gain | $5 per hundredweight | ||
| Net selling price | $64.85 per hundredweight | ||
Cash price increases more than the futures price
In this scenario, basis is said to strengthen. Assume the same conditions as in the previous examples except that here the local cash price increases to $67 per hundredweight and the futures price increases to $66 per hundredweight over the next few months (Table 3). When you decide the cattle need to go to market, you sell in the cash market for $67 per hundredweight and buy back your futures position for $66 per hundredweight. Therefore, the revenue from selling cattle is $67 per hundredweight less $1 per hundredweight lost from the futures position less any commission. Instead of selling for $67 per hundredweight, you sell for $65.85 per hundredweight.
Futures price increases more than the cash price
In this scenario, basis is said to weaken. Again assuming the same initial conditions as in the previous examples, suppose that the local cash price increases to $67 per hundredweight and the futures price increases to $69 per hundredweight over the next few months (Table 4). The revenue from selling cattle is $67 per hundredweight less $4 per hundredweight lost from the futures position less any commission. Instead of selling for $67 per hundredweight, you sell for $62.85 per hundredweight.
Futures price increases at the same rate as the cash price
Under this scenario the price you receive equals the price you would have received earlier with the exception of commissions ($0.15 per hundredweight). Again, there is no change in the basis in this example so the net price received is equal to the original price less commissions.
Table 3
Short hedge with futures as cash price increases.
| Cash price increases more than futures price | |||
|---|---|---|---|
| Cash | Futures | Basis | |
| Today $64 per hundredweight |
Sell live cattle contract at $65 per hundredweight | -$1 per hundredweight (under) | |
| Later Sell cattle in local market at $67 per hundredweight |
Buy live cattle contract back at $66 per hundredweight | $1 per hundredweight (over) | |
| Results | Selling price | $67 per hundredweight | $2 basis gain |
| Less commission | $0.15 per hundredweight | ||
| Less futures gain | $1 per hundredweight | ||
| Net selling price | $65.85 per hundredweight | ||
Table 4
Short hedge with futures as cash price increases.
| Futures price increases more than cash price | |||
|---|---|---|---|
| Cash | Futures | Basis | |
| Today $64 per hundredweight |
Sell live cattle contract at $65 per hundredweight | -$1 per hundredweight (under) | |
| Later Sell cattle in local market at $67 per hundredweight |
Buy live cattle contract back at $69 per hundredweight | -$2 per hundredweight (under) | |
| Results | Selling price | $67 per hundredweight | -$1 basis loss |
| Less commission | $0.15 per hundredweight | ||
| Less futures gain | $4 per hundredweight | ||
| Net selling price | $62.85 per hundredweight | ||
G608, new December 2000
