How many times have you, as a grower, pondered the sale of grain in case prices might fall, while still hoping that instead, it might rise further? I'm guessing it's a regular occurrence, but more often than not, no action is taken.
How much better off would you be today if you had to lock into the November 2009 price last May? You didn't, on the basis that you hoped price would be much higher when that time came.
But now you can do something to protect yourself against price movements that diverge from today's grain price.
Despite many months of falling prices, things look slightly more optimistic at the moment, but this may not hold. To sell now exposes the seller to the possibility of further price increases, or the risk of a price drop again.
If the price falls, you would be right to sell now - but if it increases, you would lose out on the increase. Being able to hedge protects the grower against the risk of falling prices.
Mechanisms have been in place in other countries for many years to help growers hedge against market movements - mechanisms like the futures market and options. However, these mechanisms better suit those who can watch them every day, and thus they are more suited to professional traders.
Last week, an Irish investment trading company, Delta Index, launched a new Agri Trading service. It provides a hedging facility for growers considering trading grain and allows them the option to manage the account themselves.
Hedging enables growers to take action to protect themselves against a fall in the value of their physical grain or 2010 crop from a given point in time.
The Delta Index Agri Trading system does not interfere with the normal trade of the grower's physical grain, but it allows the grower to trade wheat futures on the LIFFE exchange to hedge any change in value of this grain.
To date, if price falls following a physical sale, then the grower feels happy. But if the price increases, then the grower feels done. This fear of 'being done' is one of the main reasons why growers are afraid to sell forward.
For the past two years, the continuous price trend has been downwards.
How does it work?
The theory behind the Delta system is quite simple - though the practice is somewhat more complicated.
From a grower's perspective, it basically hinges around covering the value of physical grain in store against downward price movement, while benefiting from upward movement.
Hedging mirrors changes in the value of your grain, but goes in the opposite direction. For this reason, you hedge against a fall in the value of your physical grain from a specific point, while still being able to benefit from any upswing in market prices. If you want to hedge, the first thing you do is set up an account with Delta. This entitles you to training, one-to-one initial advice, simulator programmes to help you learn about the process first (these are free) and access to the online advice tools that tell you what the market - as distinct from the physical price - is doing.
The whole system is controlled by the financial regulator, and information about individual clients/hedgers cannot be disclosed by law.
Delta's payment on every transaction is the difference between the buying and selling price on the trade - called the spread.
This difference can be bigger in times of high volatility and vice versa, but the cost is normally around €1.50/t. There are no other trading or account management costs with Delta Index.
Before any hedge can be placed, a grower must lodge what is called an Initial Margin Requirement (IMR) into a Delta account. This is security for the company against the client.
This figure is normally around 10% of the value of the trade. If your hedge goes in your favour, your account will grow. If it goes against, your account will be drawn down.
At a certain point, you may need to put in additional funds if you want to continue the hedge. But the grower has control, and would normally be advised not to let this happen.
hedge example
Take, for example, the case of a grower considering the sale of 100 tonnes of wheat. The price might rise a bit more in the current buoyant market - but it could also fall very quickly.
For the purpose of simplicity, I take the value of the wheat at €130/t. The hedging process is done against the LIFFE and MATIF markets, but this end of the business is done by Delta Index.
In general, the physical price movements in this market mirror the price movements on the futures market. This is the reason why the hedge is done against the grain futures market.
With grain, one can hedge against feed wheat on LIFFE or milling wheat on MATIF. While the feed wheat is more real for us, this is a sterling transaction, and so the hedge will also involve sterling movements, which is a further complication.
It is for this reason that my example is being hedged against the MATIF market for low grade milling wheat.
When you trade with Delta, the company immediately covers your business on a specific futures market. It is important, at this point, to divorce the physical grain from the hedging process. At the point of my transaction, the MATIF price is €135/t.
Delta operates in units of 10, so buying one unit or selling one unit means 10 tonnes. The LIFFE futures has a lot size of 100 tonnes. Therefore, dealing through Delta will mean a minimum of 10 Delta units to cover the 100 tonnes required.
Table 1 deals with our example case. The first part of the table is simple - the base position or starting point. It is 100 tonnes at €135/t (MATIF price) to establish a current value of €13,500. The second part of the table explains your Delta hedge.
On the day of the hedge, you technically sell a position, which you will have to buy back sometime in the future to close your hedge.
Remember the Delta unit is 10, so the price per unit you sell at is €1,340 (for 10t). The price is less than the LIFFE above, because this is where the Delta margin is deducted.
The stake to sell is 11 units. This is 110 tonnes, and the additional 10 tonnes is advised in the hedge to cover the cost of the spread.
The hedge exposure is then 11 X €1,340 = €14,740. The figures in the table are rounded, and so differ slightly.
The stop loss is a control setting that the hedger can put in to limit losses. In this case, it is €3/t, or €30 per unit. This then sets a stop loss price level of €1,340 + €30 = €1,370. The remaining two figures in Table 1 refer to this example at a specific point in time. The IRM is €150 per unit (€15/t) for the 11 units in the hedge, which means that the hedger must lodge or have a minimum of €1,650 in his/her Delta account.
So Table 1 is the starting point - selling onto a hedge position. Now look at Table 2. This contains a new column headed 'Finish' (the closing position of the hedge) and one headed 'P&L', the profit and loss account for the hedge.
In this example, I am assuming a 10% drop in the price of grain on the futures market, so the futures price dropped to €122/t from €135/t.
This takes 10% off the value of the base position, which then loses €1,350. However, when you go to buy back your position on the hedge to close it, the Delta buying price on the day is €122.40/t.
So when you buy back the 11 lots, you generate a hedge profit of €1,273. When this is balanced against the €1,350 loss on the base position, your net loss is only €77. And you still have your grain to sell.
Normally, a grower would sell the grain at the time the hedge is closed. So the hedge has protected the grower from virtually all the loss associated with the fall in the value of the grain in store (as represented by the futures price movement). In this case, the hedge exposure remained in profit, and so the stop loss was not required.
The hedge worked for the grower, and protected him against the decision not to sell on the day the hedge was initiated. But what would happen if grain price increased?
In Table 3, I use the same scenario, but in this case, the price of grain increases by 10%. The futures price increased from €135/t to €149/t. This added €1,350 to the value of the base position (and it should have done roughly the same to the grain in store).
In this case, the buying price to close the hedge was higher than the selling price, and so the hedge account lost money. The stop loss price level set was reached and this triggered the ending of the hedge (possibly before the desired hedge period), thus limiting the loss.
But the net account position (the P&L) saw the physical grain increase in value by €1,350, with a loss in the hedge account of €330, leaving the grower with a net benefit of €1,020, providing the grain is sold when the hedge is closed.
So the hedge itself works for the grower when price falls but works against his account if price rises. Either way, the grower is hedged against the price movements.
considerations
There are a number of other points that should be noted.
Tax free profits: Firstly, all profits to the hedge fund are tax-free. So in the sell trade, when the price fell, the account gained €1,273 and this money, which is income to offset the fall in price, is tax free.
Safety limits: A range of safety devices can be used in the hedge to limit the extent of any gain or loss. It is important to remember that in this instance, a gain in the price on the futures market will mean that the hedge will lose money, but you may still be better off on balance.
The hedge versus the physical: It is important to remember that price movements in our market may not always run directly parallel to the futures, in particular the MATIF futures.
This is very evident in price movements over the past two years, but in most instances, the futures market has broadly reflected price trends.
Manage your account: Making the best use of any hedge means constant monitoring. The hedger can handle the account or can access a company person by phone. Changes to stop loss levels and new trades can be entered on a computer, or ordered by phone. There are lots of tools available to maximise the benefit to the grower.
If prices continue to rise, you can put in a sale order to lock into a level of benefit, and then recommence from a higher value on the hedge to further protect a fall from a higher value.
The hedger can close trade at any point to cease the hedge, or can change any of the internal orders.
Also for buyers: The device can also be used by buyers of grain or feed to hedge against price movement from the point of a potential purchase. In this instance, the hedger buys the stake at the start and sells at the end, while the grower sells at the start and buys back at the end.
farmersjournal.ie
Source: newsroom - meattradenewsdaily.co.uk
Back to News Headlines