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

Date Cash. Mar. 1: Est. Price $2.60 Nov. 1: Harvest & $2.40 Futures. Sell: Dec. $3.00 Buy: Dec. $2.80

The Producer’s Hedge Date Cash. 3/1: $ /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 = $ futures gain = $0.20 Total return = $2.60 Note: Estimated return = $2.60

The Processor’s Hedge

Date Cash. Mar. 1: Lock in $5.40 Nov. 1: $7.00 Futures. Buy: $5.70 Sell: $7.30

The Processor’s Hedge Date Cash. 3/1: $ /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 = $ futures gain = -$1.60 Net cost = $5.40 Note: Estimated price = $5.40