After spending much of the three months over harvest doing very little, volatility is back in the wheat market. Canola has been on a rollercoaster for the best part of a year, with little price certainty going forward. This week we look at alternative price protection tools for producers.
While there are a number of ways to market physical grain, there are always a myriad of ways to protect future pricing. Most growers would be familiar with futures contracts, or swaps, which fix a price that is closely related to the price of the commodity which is being produced.
If futures, or swaps, are sold, and the price of the commodity falls, at settlement the grower will receive cash. The physical price will have also fallen, so the grower will receive less for the physical, but be compensated by the proceeds of the futures or swap, thereby netting the price originally locked in.
If the price rises, physical proceeds are higher, but a payment must be made to settle the futures or swap, with the net price again being the original amount. There is a basis risk in futures and swaps, which is the risk of the physical price diverging from the futures contract. For growers, this is only a problem when physical wheat prices are much lower than futures prices.
Options are another way of protecting prices where a premium is paid to fix a price. For growers, put options basically put a floor in the futures price. Figure 1 shows how payouts work on a basic put option versus a swap or taking the spot price.
In this example, we’ve got a put option with a strike (or floor) price of $355/t (we’ve converted SRW pricing to AUD/t for ease of understanding). The premium, or cost, of the option is $21. This gives an effective floor price of $334/t.
On the X axis is the market price at settlement. If the market increases, the effective price will be the spot price minus the premium. If the market falls below $355, the effective price will remain at $334.
For comparison, a swap price is shown in Figure 1, which simply shows a flat effective price no matter what happens with the market price at settlement.
What does it mean?
With such uncertainty in the market at the moment, paying a premium to fix a floor price is a valid hedging strategy. Losses are limited to the premium price, but the upside is unlimited if there are some issues somewhere in the northern hemisphere.
Options can be traded through banks or directly on the exchange for those confident enough, or with licensed derivatives advisors.
Key Points
- Grain markets are showing volatility, with plenty of uncertainty going forward.
- Swaps and futures are relatively straightforward, but put options offer a different strategy.
- Paying a premium for a floor price might be a good strategy in highly uncertain times.
Click on graph to expand
Data sources: CME, Mecardo
