Speculation vs. Hedging

Section 4

Speculation

What is speculation?

Taking a position in the market in order to make money on the rise and fall of futures prices of certain commodities.

Speculation

Buy a contract at a low price, then turn around and sell the contract at a high price.

Buy low, sell high.

Speculation

Sell a contract at a high price, then turn around and buy the contract at a low price.

Sell high, buy low.

Speculator’s Role

Provides risk capital Provides volume and liquidity Keeps some markets in alignment through

arbitrage

Why Speculate?

Increase a small amount of money to a large amount of money

Supplement Income Stimulation of the game

Why have rules?

Less than 25% of all

speculators

are successful

Rules for Speculation

Use money you can afford to lose Know yourself Don’t overcommit Don’t trade too many commodities When you are not sure - stand aside Block out other opinions Trade the most active contracts

Rules for Speculation

Never put your entire position on at one price

Never add to a losing position Cut your losses short Let your profits run Learn to like losses Use stop orders Get out before contract maturity

Rules for Speculation

Learn to sell short Don’t reverse your position Avoid picking tops and bottoms Take a trading break Buy bullish news, sell the fact Act Promptly Don’t form new opinions during

trading hours

Manner in Which Speculators Trade

Position Trader Day Trader Scalper Spread

Spreads

Simultaneously taking a long position in one futures contract

against a short position in another futures contract

Types of Spreads

Interdelivery spread – futures contacts for the same commodity traded on the same exchange are spread between two different delivery months

Example: July Wheat and

December Wheat

Types of Spreads Inter-market Spread

Example: Chicago Wheat and Kansas City Wheat

Inter-commodity Spread Example: Corn and Oats

Commodity-Product Spread Example: Soybeans and Soybean

Oil or Meal

Hedging

What is hedging?

Taking an equal and opposite position in the futures market to that in the cash market in order to insulate one’s business against price level speculation.

Why hedge?

Too much price risk Highly leveraged Some banks require it as part of a

loan agreement

Causes of Price Risk

Time difference between production and marketing

Uncertain nature of farm production

National or international policies

The Producer’s Hedge

The Producer’s Hedge

Date Cash .

Mar. 1: Est. Price $2.60

Nov. 1: Harvest & sell @ $2.40

Futures .

Sell: Dec. futures @ $3.00

Buy: Dec. futures @ $2.80

The Producer’s Hedge

Date Cash .

3/1: $2.60

11/1: Sell $2.40

-$0.20

Futures .

Sell: $3.00

Buy: $2.80

+$.020

The Producer’s Hedge

The producer sold crop at $2.40 in the market at harvest.

Bought back the futures contract for $2.80.

The Producer’s Hedge

The producer gained $0.20 in the futures market to add to earnings in the cash market.

The Producer’s Hedge

Nov. 1 cash price = $2.40

+ futures gain = $0.20

Total return = $2.60

Note: Estimated return = $2.60

The Processor’s Hedge

The Processor’s Hedge

Date Cash .

Mar. 1: Lock in $5.40

Nov. 1: Buy @ $7.00

Futures .

Buy: Mar. @ $5.70

Sell: Mar. @ $7.30

The Processor’s Hedge

Date Cash .

3/1: $5.40

11/1: Buy $7.00

Futures .

Buy: $5.70

Sell: $7.30

+$1.60

The Processor’s Hedge

Processor bought grain for $7 in cash market. Sold futures contract for $7.30. Gained $1.60 in the futures market to help cover

cost of grain purchased.

The Processor’s Hedge

Nov. 1 cash price = $7.00

+ futures gain = -$1.60

Net cost = $5.40

Note: Estimated price = $5.40