Each day on average, commodity grain futures markets facilitate over 1 million trades as market participants respond to technical and fundamental market signals — two topics we’ve covered in previous articles (“Technical Analysis” and “Fundamental Analysis”).
But who are these market participants?
Broken down to the most fundamental level, these participants fall into two camps: hedgers and speculators.
These are terms used to describe the participants’ motivation when making trades. Importantly, neither group is more important than the other. Efficient and effective markets require participation from both, otherwise we could not find a true price for any commodity.
A hedger’s fundamental objective is to mitigate the price risk of their owned physical commodity. The phrase “to hedge a bet” first appeared in 1672 in a theater performance, but the term is generally used to indicate that one is creating some barrier — a shrub-like hedge — between oneself and something else.
In financial terms, this is to counterbalance a financial position with an opposite position. This may seem counterintuitive, as it may appear that hedging in this manner would yield a net zero return (the profit from one position would equally counteract the loss from another).
But an effective hedge is not a zero-sum game. Instead, an effective hedge places a stop against dramatic price swings which ultimately yields a return.
Hedgers are those in the market who actually own or purchase the physical commodity they trade. In agriculture, there are many hedgers: farmers, ranchers, grain elevators, ethanol producers, stocker cattle operators, milk buyers, feedlots, sale barns and grain mills just to name a few. These entities all at one point or another own a physical commodity, be it grain, milk, cattle, etc.
Their goal is to offset the financial loss (or gain) of value of that physical commodity during the period they own the commodity.
For example, an observant farmer may recognize that the price of corn at harvest, measured by the December corn futures price, is sinking lower and lower. Since the farmer will own the corn this fall that they grew, they may decide to hedge their price risk by creating a “price floor” for their corn.
A price floor is a minimum price that one can receive set at a level that is still profitable.
There are numerous ways for sellers to create these price floors and price ceilings for those who buy physical commodities. This could involve forward contracting sales and/or purchases of the physical commodities. The observant farmer from before could call their local elevator in May and contract corn to be delivered at harvest. Those bushels are “priced” and will not decline in value, thereby creating a floor.
A seller or buyer could also trade futures and options on the Chicago Mercantile Exchange to hedge their position. For example, the farmer who wants to set a harvest price floor for corn in May could sell a December corn futures contract. They plant, grow and harvest the crop. If the price has declined, they can then buy back the December corn futures contract at the lower price which gives them a profit on the futures contract. This profit will offset the decline in the cash price that they receive for their corn thus creating a price floor.
You might have heard the term “paper farming” in regard to trading “paper” or securities in the futures market. This term refers to hedging performed by creating offsetting positions in the futures market relative to the physical cash market — your local elevator, sale barn, etc.
We will discuss futures and cash market hedging strategies in greater depth in future articles.
Fundamentally, our goal is to receive a profitable price for our marketed commodities, and do so by managing price risk.
