Trading futues contracts

[errolanderson]

Trading is another tool in your marketing toolbox.

There are times when signing a cash contract may be your strongest strategy. There are times when using your commodity trading account is the tool of choice. A farm market plan is usually a blend of both. When basis levels are weak and wide, hedging, sell the futures or scale in put options is an effective strategy.

Recently, cattle feeders hedging their fat or feeder cattle have made their entire winter feeding profits through the short cattle hedges. Feeding cattle for next to nothing this winter was propped-up and covered by their hedge positions. That was the feeding profit.

New crop canola pricing via put options guard a floor price without production or delivery obligations.

Futures trading is a marketing tool, but must be respected. To speculators, futures trading can kick your ass. Anyone ****y with futures will learn a lesson of market respect. But it is a valuable risk management tool for those that can manage positions and watch that basis.

[Oliver88]

What is an example of a call option or future contract to protect a farm against a rise in diesel fuel prices?

[mbratrud]

I’ve never traded on the board, thinking of it.

How many contracts in one trade should a rookie do?

Thanks for any replies.

Are you using as a hedge or are you speculating?

[TechAnalyst]

What is an example of a call option or future contract to protect a farm against a rise in diesel fuel prices?

This may be one of the most complex hedges (regarding considerations) that one can establish. That said, this exceptional situation we find ourselves in certainly makes it worth looking into.

The first question to answer likely is - should I? Given the extreme volatility, it could be quite expensive to put on and maintain a hedge strategy. Whether a futures or options position is used, the volatility adds to the financial commitment. If Covid19 is actually reducing world consumption by 20 mil barrels of oil per day, there should be more concern about running out of storage space than there is about prices rising. Even the 10mb/day cut in production that was floated today would likely just slow the build in supplies. The best move may be to just monitor the situation and keep your tanks full as long as prices stay low. Once it looks like the world figures out how and when to start returning to normal, then consider the strategies that follow.

There are a few difficulties to consider,

The proper futures contract, Ultra Low Sulfur Diesel-ULSD (HO), is large – 42,000 US gal or 159,600 litres

It has very few options trading (still doable), no mini sized contract, priced in US$

Crude oil futures contracts can be used but they too are a very large 1,000 barrels

They have significantly better options liquidity but prices can move independently of ULSD

They do have a mini contract of 500 barrels (roughly equivalent to 80,000 litres of diesel)

In either case there can be large fluctuations in the basis (futures price less local pump price) given the processors being in Western Canada, selling refined products in Can$.

The cost of carry is large with petroleum products (storage, insurance, etc) so deferred contracts trade at a premium at any given time. For example, May HO is $1.0081/gal while July HO is trading at $1.0601 and November at $1.1845/gal. Over time, if there is nothing to increase the spot price, those deferred contracts drop in value to the cash price (as the remaining cost of carry declines). As such, going out too far in the future to protect yourself locks in the higher value, not what you are attempting to accomplish.

The best way to look at the process is it will be imperfect but it still can be well worth while.

Back to the original question, given the volatility, I would recommend using July HO options. They expire June 25th so would provide protection until the tanks are filled prior to harvest, close enough. For reference, July HO was $2.07/gal on Jan 8th, $0.9823 on Wednesday, and $1.0601 today.

You can buy a July $1.30 call today for $.0615 x 42,000gal or $2,583 US plus $70 commission

In the simplest terms, that should protect about 70% of the price decline in your cash prices since the start of the year on 160,000 litres.

Given most farms wouldn’t come close to that level of use, any move in price over $1.30/gal (July futures) would actually work in your favour – you would be over insured.

You can lessen the cost by going with a higher strike price (poorer protection) as well.

The alternative is to simply buy a mini Crude oil futures. Keep in mind, there would be a very significant margin requirement here and even a move back below $20/bl from the current $25 would result in a loss of $2,500 (presumably offset by lower cash fuel prices should the futures stay down there). I would suggest this for those comfortable with futures trading only given the current volatility.

Sorry about the length…

[samhill]

Thanks much for all replies, a wealth of info from here. I’ll study the mechanics a little more, and think I’ll try options in corn to begin, May not make much but will get some experience as suggested.

I know, “ Experience is what you get when you get what you don’t want.”

[farming101]

Good explanation Tech, I would go with the call option of ULSD. Maybe try to work a CAD cross hedge into it too. Need not be in the markets. Start up a USD acct. Regardless, all this price protection requires your money or demands risk up front. The markets are like life, the test is given first, then the lesson

[Oliver88]

Very good information Techanalyst, interesting to see if we can take advantage of low prices in other ways than buying more storage and filling tanks.

The July Heating Oil call option sounds like an alternative that could be utilized.
The 42,000gal contract is the standard size and there is no mini contract?

[TechAnalyst]

Unfortunately there are no mini contracts that I am aware of for HO (ULSD).

I didn't want to make it any more complicated than it already was but you can reduce the cost by reducing the coverage, making it more affordable on a smaller quantity.

In other words, you could buy a July $1.50/gal call option for $.0318 x 42,000 gal or $1336 US plus $70 commission (instead of $2,583 for the $1.30/gal call). It only protects about half of the break instead of 70% but is better than no protection at a reasonable price. That could get you down to about $.05/litre C$ on a 40,000 litre use farm.

And yes farming, the exchange rate consideration should be worked into it as well. I was trying to balance how detailed to get for the example.

One other point worth mentioning. Try not to buy calls on strong up days. The oil market has had a strong short covering rally ahead of talks to try to reduce output. The calls have doubled in price since Wednesday. The best time to buy them is once the optimism has faded and crude prices pull back or at least consolidate.