Wheat producers can hedge against falling wheat price by taking up a position in the wheat futures market.
Wheat producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of wheat that is only ready for sale sometime in the future.
To implement the short hedge, wheat producers sell (short) enough wheat futures contracts in the futures market to cover the quantity of wheat to be produced.
A wheat grower has just entered into a contract to sell 500,000 bushels of wheat, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of wheat on the day of delivery. At the time of signing the agreement, spot price for wheat is USD 5.7000/bu while the price of wheat futures for delivery in 3 months' time is USD 5.7000/bu.
To lock in the selling price at USD 5.7000/bu, the wheat grower can enter a short position in an appropriate number of CBOT Wheat futures contracts. With each CBOT Wheat futures contract covering 5,000 bushels of wheat, the wheat grower will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the wheat grower will be able to sell the 500,000 bushels of wheat at USD 5.7000/bu for a total amount of USD 2,850,000. Let's see how this is achieved by looking at scenarios in which the price of wheat makes a significant move either upwards or downwards by delivery date.
As per the sales contract, the wheat grower will have to sell the wheat at only USD 5.1300/bu, resulting in a net sales proceeds of USD 2,565,000.
By delivery date, the wheat futures price will have converged with the wheat spot price and will be equal to USD 5.1300/bu. As the short futures position was entered at USD 5.7000/bu, it will have gained USD 5.7000 - USD 5.1300 = USD 0.5700 per bushel. With 100 contracts covering a total of 500000 bushels, the total gain from the short futures position is USD 285,000
Together, the gain in the wheat futures market and the amount realised from the sales contract will total USD 285,000 + USD 2,565,000 = USD 2,850,000. This amount is equivalent to selling 500,000 bushels of wheat at USD 5.7000/bu.
With the increase in wheat price to USD 6.2700/bu, the wheat producer will be able to sell the 500,000 bushels of wheat for a higher net sales proceeds of USD 3,135,000.
However, as the short futures position was entered at a lower price of USD 5.7000/bu, it will have lost USD 6.2700 - USD 5.7000 = USD 0.5700 per bushel. With 100 contracts covering a total of 500,000 bushels of wheat, the total loss from the short futures position is USD 285,000.
In the end, the higher sales proceeds is offset by the loss in the wheat futures market, resulting in a net proceeds of USD 3,135,000 - USD 285,000 = USD 2,850,000. Again, this is the same amount that would be received by selling 500,000 bushels of wheat at USD 5.7000/bu.
As can be seen from the above examples, the downside of the short hedge is that the wheat seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling wheat prices while still be able to benefit from a rise in wheat price is to buy wheat put options.
To buy or sell futures, you need a broker that can handle futures trades.
OptionsHouse is a full fledged Futures Commission Merchant that provides a streamlined access to the futures markets at extremely reasonable contract rates.Click here to open a futures trading account at OptionsHouse.com now!