Hedging Against Falling Wheat Prices using Wheat Futures

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How Are Futures Used to Hedge a Position?

Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price. The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price.

The ultimate goal of an investor using futures contracts to hedge is to perfectly offset their risk. In real life, however, this can be impossible. Therefore, individuals attempt to neutralize risk as much as possible instead. Here, we dig a little bit deeper into using futures to hedge.

Key Takeaways

  • Futures contracts allow producers, consumer, and investors to hedge certain market risks.
  • For instance, a farmer planting wheat today may sell a wheat futures contract now. He will then buy it back come harvest when he sells his wheat – effectively locking in today’s price and hedging away market fluctuations between planting and harvest.
  • Because futures contracts often require actual delivery of the underlying at expiration, hedgers must be sure to exit or roll over positions before expiry.

Using Futures Contracts to Hedge

When a company knows that it will be making a purchase in the future for a particular item, it should take a long position in a futures contract to hedge its position. For example, suppose that Company X knows that in six months it will have to buy 20,000 ounces of silver to fulfill an order. Assume the spot price for silver is $12/ounce and the six-month futures price is $11/ounce. By buying the futures contract, Company X can lock in a price of $11/ounce. This reduces the company’s risk because it will be able to close its futures position and buy 20,000 ounces of silver for $11/ounce in six months.

If a company knows that it will be selling a certain item, it should take a short position in a futures contract to hedge its position. As an example, Company X must fulfill a contract in six months that requires it to sell 20,000 ounces of silver. Assume the spot price for silver is $12/ounce and the futures price is $11/ounce. Company X would short futures contracts on silver and close out the futures position in six months. In this case, the company has reduced its risk by ensuring that it will receive $11 for each ounce of silver it sells.

Futures contracts can be very useful in limiting the risk exposure that an investor has in a trade. The main advantage of participating in a futures contract is that it removes the uncertainty about the future price of an item. By locking in a price for which you are able to buy or sell a particular item, companies are able to eliminate the ambiguity having to do with expected expenses and profits.

Sometimes, if a commodity to be hedged is not available as a futures contract, an investor will instead seek out a futures contract in something that closely follows the movements of that commodity, for example buying wheat futures to hedge the production of barley.

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Wheat Futures: Key Trading Principles

The group of fixed-term contracts for agricultural products (for example, corn, oats, livestock or cotton) is one of the oldest instruments of commodity exchanges. In particular, the long story boasts and financial derivative on wheat. The importance of crops for the global agricultural industry is extremely high, which ensures the highest liquidity of cereal plant futures.

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Today, within one trading day, traders with the goal of increasing their income or manufacturers with the goal of hedging their risks buy more than 56 thousand contracts for Chicago stock exchange CBOT. Futures are gaining additional attractiveness due to the high volatility that opens up the possibility of earning in short-term trading.

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Daily trading volume in wheat futures for January 22, 2020 (in contracts). Source: CME Group

There are an incredible number of wheat varieties that differ from each other in such characteristics as hardness, color, length and place of growth. Among them, the most popular can be called cereal grown in the United States. Accordingly, the futures for American wheat is the most liquid in the world.

Futures contract specification details:

  • Futures traded on Chicago CBOT with ticker ZW
  • Grade of supplied wheat – red soft winter wheat
  • The volume of supply of raw materials – 5 thousand bushels (about 136 tons)
  • The minimum price increment is 1/4 cents per bushel (12,5 USD per contract)
  • Trading hours on Globex electronic platforms – evening session (Sunday to Friday) 19:00 – 7:45 CT (Central Time); afternoon session (Monday to Friday) 8:30 – 13:15 CT.

The most active tradersAs a rule, it is observed closer to evening time in Moscow (from 19:00 to 22:30). When calculating the final wheat price for futures, both electronic trading data on Globex platforms and the results of open trading of outcries, which are held from Monday to Friday from 8:30 to 13:15 CT, are used.

Monitoring Tools for Traders in Wheat Futures

To determine the factors affecting the movement of the value of wheat, it is first necessary to limit areas of use this cereal crop. The key areas of its application are livestock feed production. In addition, a large proportion of the total produced volume falls on bakery and pasta. There are other, less popular uses for wheat. For example, due to the high concentration of active nutrients, cereal extract strengthens the immune system and accelerates the healing process of wounds, therefore it is included in the composition of medical preparations. In addition, due to the presence of powerful antioxidants, it retains youthful skin and is a component of many cosmetics. However, the significance of these industries in the context of determining the world value of wheat is negligible.

Data on the volumes of actual and / or expected produced and / or delivered raw materials – the main reference point for the analysis of the further direction of price movement. They are closely related to weather conditions in wheat-growing countries. Over the past twenty years, China has confidently held the palm of leadership in the global production of this cereal (more than 115 million tons in 2020), followed by India (80 million tons), the USA (60 million tons) and Russia (41 million tons). By the way, in 2020 the level of production of Russian raw materials was supposed to increase by 50%, but the abnormally hot and arid summer did not allow to realize the ambitious plans of the government. In the “common boiler” of production, the share of the Eurozone is also large: the volume of grain harvested comes primarily from France, Germany and the UK.

The volume of wheat production. Source: Wikipedia Online Encyclopedia

Another factor that determines the direction of the wheat price curve is product demand dynamics. Among the main consumers of cereal crops, one can distinguish the European Union, China and India. The latter is currently planning to increase exports, thereby creating a certain excitement in the market. It is important to consider that the pressure on wheat futures quotes is exerted not only by the statistics of production and consumption of cereal, but also by the general economic and political situation in the largest producing countries and importers. For example, 2007-2008 global financial crisis left a significant imprint on the value of many commodities and agricultural goods. During the period of serious economic problems, the price of wheat soared to a record high of 1282,50 cents per bushel (March 2008).

ZW Futures Wheat Price History. Source: SaxoTrader Trading Platform

Unlike, for example, fixed-term contracts for energy or precious metals, wheat futures have cyclical dynamics within one year. The decline in activity, as a rule, occurs in the first half of the year (from January to May), and the second half of the year usually passes with an upward trend. Harvesting a new wheat crop begins in July, so this is exactly the month that investors should carefully monitor the news and trends on the chart, since the likelihood of a reversal from mid-summer to late September is especially high.

If we talk about specific reports that are useful for a trader in wheat futures, it’s worth mentioning Crop progress reportthat comes out weekly. He will talk about the degree of ripening of crops and help determine the approximate date of harvest. Another significant statistical document – US and World Supply & Demand Report – monthly helps to get an idea about the balance of global demand and supply of raw materials.

Comparison of the dynamics of futures for wheat (ZW) and corn (ZC). Source: SaxoTrader trading terminal

Derivatives for basic agricultural products, being influenced by similar factors, note a high correlation inside your group. The same direction of prices for agricultural products arises due to the fact that in most cases the same countries are the key producers and consumers. For example, the futures price of wheat and corn shows a high level of interconnection (see illustration above). Particularly strong dependence during periods of consolidation. The sharp movements of the graphs to the highs or lows also coincide. However, it makes sense to speak here about the presence of the same trends, since the time of their implementation may differ. Recently, analysts often mention the pressure of the price of corn on the value of wheat. One way or another, the presence of a high correlation cannot be denied, which means it should be taken into account when analyzing and forecasting quotes.

The current situation in the wheat market

Wheat Futures ZW. Source: SaxoTrader Trading Platform

Supporting the downward trend, which covered almost the entire group of agricultural commodities, the trading volume of wheat futures contracts for 2020 decreased by almost 4% (from 1,439,517 in December 2020 to 1,383,342 in December 2020).

In December 2020, stable weakness was observed with a smooth rollback in the corridor 675,00-600,00, which is explained by the seasonal December lull and the expectation of annual reports to determine the future strategy. As a result of a decrease in demand for American wheat and a simultaneous increase in raw material production to record levels (more than 711 million tons) in January 2020, quotes fell to their lowest level since mid-2020. The timid upward trend that has emerged today has arisen due to fears of a harvest loss, as frosty weather with low rainfall has set in the northern regions of the United States.

Wheat futures are in great demand among manufacturers who, with their help hedge risks price spikes. In addition, these contracts are also useful for traders who play volatility in the short or long term.

Sergey Krasikov, Senior Financial Advisor, Saxo Bank in Russia

Saxo Bank Analytical Department

Saxo Bank experts daily offer predictive analytical materials about the sought-after assets and markets to their customers in different languages. These are specialists with many years of trading experience and experts in their field.

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