Are you speculating or hedging?

Corn

There was another USDA report last week estimating usage and carryout. It had few surprises; corn carryout raised slightly (this was projected in the March 31st stock reports), which means there is more corn stored on the farm than the trade previously estimated.

Expect little corn excitement in the next two months. With plenty of old crop corn, the U.S is not competitive in the world markets as prices approach $4.00. On the other hand, farmers won’t sell below $3.75. A large weather event in May or June would probably be the only reason this trading range would change in the short-term.

 

Beans

It’s hard to be bullish beans. The U.S. and the world for that matter has a mountain of beans in storage and plans to plant record acreage this year are forecasted. The only potential is that it’s a long time to August and making the crop is still open to weather issues.

 

Are you speculating or hedging?

Many grain marketing analysts have been predicting futures prices will rally from current levels, advocating farmers should buy calls on any grain they already have sold for new crop. I cringe slightly with this advice, because its effectively telling farmers to become speculators.

 

Why is the strategy to “buy a call” speculating?

Buying calls means farmers are buying the right to “re-own” grain at a set price in the future. Or, the farmer is choosing the right to own more grain. But, farmers have no inherent reason to buy grain. Farmers are always producing more grain. Maybe not tomorrow, but they will eventually and continually. The average 500- to 600-acre corn farmer raises 100,000 bushels per year, or 500,000 over the next five years. Therefore, I rarely recommend farmers buy calls. Instead, I suggest rallies in the market should be met with more selling.

Making it even more speculative, many farmers have unpriced old crop left to sell and very little new crop sold. Farmers in this type of position need to realize their increased risk exposure with buying calls. What if the market does not rally? How much worse will their financial position be?

 

Betting on the market

Farmers should think about the market this way — the market can move in three different directions at any time: up, down or sideways. So, there is essentially a 33% chance that one of these directions can happen. Market analysts can do their best to predict prices, but they can be wrong and no one really knows where the market is going to go. Assuming the market will rally, and therefore buying calls, should on average lose money 66% of the time. Because, prices could stay stagnant, as they have the last three months and the farmer would lose all of the premium paid for the call. Or prices could decrease further, and obviously the farmer would lose the whole value of the call. Yes a call has limited risk, but it’s still risk of loss.

 

The details on why I don’t recommend buying a call

One analyst made the above recommendation when July corn was trading around $3.85 and Dec corn was trading at $4. Looking at an example, the cost to a farmer would be 20 cents for either the July $4 call or the Dec 4.50 call. While I might agree with the analysts that the corn board could increase, in my opinion betting that the price increase will be above the breakeven points after buying the calls is unlikely and has limited risk of a loss of 20 cents.

Buying one of these call means prices need to hit $4.20 before late June for the July call or $4.70 by late November on the Dec call. Is it possible? Yes. Is it probable? I don’t know. Right now many think it’s more probable that old crop stocks will hold the July market back and thus less likely to happen. It would take a weather event for Dec to rally, but no one knows if that will happen or not.

Farmers should ask themselves when buying calls, “would I buy Dec $4.70 corn (or $4.20 July) or sell at $4.70 on the Dec (or $4.20 July) if we reach those price levels?”

 

My farm example

I always tell farmers to take the cost of the call into account before deciding to put it on. I have our 2015 crop sold at $4.71 Dec futures. I could buy a $4.50 call this week for 20 cents, making my selling price guaranteed at $4.51 ($4.71- 20 cents for the call). This means I would have all the upside potential in the market (assuming a weather event occurs) because I bought a $4.50 call and my guarantee is basically the same price. BUT, do I really want to take 20 cents less if the market DOESN’T rally? Straight odds say the market only has a 33% chance of going up.

 

So you never recommend buying calls?

No, there are times when it makes sense. Even the example above for my farm looks tempting on a few bushels. I tend to recommend them with part of the crop that is not covered by insurance or if I fear a production issue. I also tend to use them more for soybeans than corn, but the principals are the same for both. It depends on my market strategy and goals during the year.

Buying calls like this is similar to “trying to hit the home run.” I understand the mentality of wanting to “hit the home run.” Who doesn’t? But, realistically the chances are low you can hit it (especially every time). And, the risk to the farmer hitting the bottom increases. In marketing grain for our farm and advising my clients, I rarely take the “hitting for the fences” strategy. I prefer to win the game with small single hits every time. While boring to some, a strategy that probably will not hit the top, but avoids hitting the bottom, is a proven winner year after year.

Jon grew up raising corn and soybeans on a farm near Beatrice, NE.  Upon graduation from The University of Nebraska in Lincoln, he became a grain merchandiser and has been trading corn, soybeans and other grains for the last 18 years, building relationships with end-users in the process.  After successfully marketing his father’s grain and getting his MBA, 10 years ago he started helping farmer clients market their grain based upon his principals of farmer education, reducing risk, understanding storage potential and using basis strategy to maximize individual farm operation profits.  A big believer in farmer education of futures trading, Jon writes a weekly commentary to farmers interested in learning more and growing their farm operations.

 Trading of futures, options, swaps and other derivatives is risky and is not suitable for all persons.  All of these investment products are leveraged, and you can lose more than your initial deposit.  Each investment product is offered only to and from jurisdictions where solicitation and sale are lawful, and in accordance with applicable laws and regulations in such jurisdiction.  The information provided here should not be relied upon as a substitute for independent research before making your investment decisions.  Superior Feed Ingredients, LLC is merely providing this information for your general information and the information does not take into account any particular individual’s investment objectives, financial situation, or needs.  All investors should obtain advice based on their unique situation before making any investment decision.  The contents of this communication and any attachments are for informational purposes only and under no circumstances should they be construed as an offer to buy or sell, or a solicitation to buy or sell any future, option, swap or other derivative.  The sources for the information and any opinions in this communication are believed to be reliable, but Superior Feed Ingredients, LLC does not warrant or guarantee the accuracy of such information or opinions.  Superior Feed Ingredients, LLC and its principals and employees may take positions different from any positions described in this communication. Past results are not necessarily indicative of future results. He can be contacted at jon@superiorfeed.com.

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