A question that comes up from time to time is the difference between hedging and speculating, and where to draw a line between the two. By definition, hedging involves taking a contract or position in the market that is risk-reducing, thereby cutting one’s exposure to price fluctuations. Speculating by contrast would be the opposite, to contract or take a position in the market that increases one’s price exposure. While this may seem fairly straightforward such that it can be distinguished in black and white terms, in reality there are shades of grey. Yet, there are some general guidelines that can help define when a position is more a hedge or a speculative trade. Many producers and lenders are understandably concerned about this topic as trading involves capital and the possibility of losing that capital in the market. To the extent that these potential losses are offset by gains elsewhere, that is not necessarily a problem. However, if these losses compound other losses, then that can become problematic and reduce the effectiveness of one’s hedging program.
Differentiate by Delta
A few examples may help to distinguish between hedging and speculating. First, let’s assume a crop farmer is getting his fields ready for spring planting and contemplating his marketing strategy for the upcoming season. The market remains depressed and has been under pressure recently so the prospect of selling the crop at current price levels is not attractive. The farmer does anticipate though at some point during the summer growing season there may be a better opportunity to establish a sale against their crop production. While summer price spikes can and often do occur as a result of weather or other developments, it can be difficult to determine at what point they will become exhausted and prices turn lower. In some cases like the past two summers for example, the move will be brief and prices will retreat quickly. In other years like 2012, the move may be sharper and more extended.
Knowing that it is impossible to time the market and pick highs, the producer decides to pre-emptively buy call options against their anticipated sales which they will likely make later in the season. Because a call option provides the right but not the obligation to purchase futures at a pre-determined price, this effectively becomes insurance against the possibility of a 2012 scenario where the market will run away from the producer after he commits to a sale. While there is not necessarily anything wrong with this strategy at face value, buying calls represents a long position in the market. Without any other positions or contracts other than the physical ownership of the crop, this pre-emptive purchase of call options actually increases the producer’s length in the market. This gets into the grey area. Buying calls is not a hedge by itself; however, when combined with a sales commitment either in the cash market or on the board, the package becomes a minimum price contract which is a legitimate hedge.
The reason a producer would want to buy call options pre-emptively ahead of selling futures or establishing a forward contract or hedge-to-arrive in the cash market is that the calls will be cheaper when the market is depressed. It may also be the case that volatility is low which will also make the call options less expensive to purchase. Because the capital exposure on the position is limited to the cost of the option’s premium, the strategy is less speculative in nature but it still is a long position in the market. It doesn’t truly become a hedge until it’s combined with an actual sale at a later date. If the market moves higher and a sale is established, the position will be effective and perform as desired. If the market continues to move lower though, the producer will ultimately have a loss on the expired call option that will reduce their eventual sale price, which is why this falls into the grey area as it may increase the producer’s risk.
As a second example, let’s assume a dairy producer sold a futures contract earlier this year to lock in a sales price for their summer milk production. The price at which they sold the futures contract is now well above where the market is currently trading. Because of this, they have built up quite a bit of equity on their position and are now concerned that prices may possibly turn higher if the spring flush is poor or other developments cause a market rally. They therefore consider buying a call option against their futures contract to protect that sale and their accumulated equity from rising prices. Like the crop example, the dairy producer is essentially looking at the call option as insurance against their existing hedge position. Some may mistakenly believe this trade is speculative; the dairy producer is committing capital to purchasing calls with the expectation that the market is going to move higher.
However, while the call option in both examples is a long position in the market, the difference is that in the case of the dairy farmer, there is already a sale price established. As such, the call option would not be creating additional length and risk; it would simply be reducing the degree to which the existing hedge position is short. By converting a fixed sale price into a minimum price, the dairy producer is merely changing the character of their hedge, not adding to their directional risk. In the November issue of Margin Manager, we discussed the concept of delta and how to measure it. One way to determine whether a position is speculative is to look at the net delta of the position. If the delta is the same sign as the risk exposure in the cash market, then the position is speculative. If the net delta of the position however is the opposite sign of the exposure in the cash market, then the position is a hedge.
The dairy example is a case of making an adjustment to an existing hedge position. Some confusion may arise from a focus on the adjustment itself, and not the net resulting position. While buying a call option is a long position in the market and has a positive delta, the net delta of the dairy producer’s position remains negative. In the crop producer’s example, the only position initially is the long call option that has a positive delta which is simply compounding the length and exposure in the market given the ownership of the physical crop.
Another issue that creates confusion on whether a position represents hedging or speculating concerns the placement of a hedge. Generally speaking, any hedge represents a substitute for a physical purchase or sale in the cash market. As a result, the placement of the hedge should correspond, roughly, with the anticipated timing of the purchase or sale in the local market. Going back to the crop example, the producer considering the pre-emptive purchase of a call option against their upcoming production would want to choose not only a strike price that would correspond to their anticipated selling target, but also an expiration or maturity that aligned with their expected selling date. The dairy producer similarly would opt to buy a call option against the same contract month or expiration of the short futures position, in order to harmonize the two.
It may be the case in other instances where more than one contract might represent an appropriate hedge to offset an exposure in the cash market. As an example, a hog producer or cattle feeder might be looking at their exposure against animals on feed. Within a feeding cycle, there may be contracts that overlap such that more than one contract might be used or considered in a hedging strategy. A hog producer for instance covering summer production might be looking at a combination of the June, July and August contracts to mitigate their risk exposure. A cattle feeder might similarly look at a combination of August and October contracts for steers currently on feed. While a strict hedge policy would dictate that the contract mix should match as closely as possible the production flow and physical exposure in the cash market, in practice, there may be practical reasons why hedges are not perfectly allocated this way.
Let’s assume that for a deferred hedge position, there is a lack of liquidity in particular contract months such that it would be easier to execute a position if it were in a closer expiration. Going back to the hog example, while the summer production flow and risk might be distributed among the June, July and August contracts, there may be more liquidity in the June contract compared to July and August where it might make sense to front-load all of the hedges into the nearby expiration. While this might be considered speculative and does imbed a spread risk into the hedge relative to how hogs will be priced into the cash market, the perceived spread risk may be smaller than the larger price risk in a falling market, and the hedges could always be reallocated to the appropriate months later when deeper liquidity materializes in the deferred contracts.
The decision to front-load a hedge as in the previous example may also be deliberate as the result of a spread bias the hedger has. To illustrate this, let’s assume that the cattle feeder who will be marketing steers currently on feed against both the August and October contracts feels that the August contract is overvalued relative to October. They may choose to allocate hedges that would normally be placed in the October expiration to the August contract instead, with the expectation that August will decline in price relative to October. If they are correct in their assumption, they can eventually roll the hedge to the October contract following a change in value between the two. Here again, this hedge placement issue and the topic of front or back-loading hedges falls into a grey area that borders on speculating. While there is a spread risk imbedded into the hedge position when this is done; if the contracts are close together in maturity such as successive months in these examples, there may be good reasons to consider this practice with disciplined guidelines under certain circumstances.
Good Policy Makes Good Practices
While everyone’s hedge policy will be different with some more strict than others, there are some general guidelines that can help set direction and limit excessive risk taking. For starters, the delta of a hedge should always be the opposite direction of the underlying cash market risk. Someone who is long in the cash market and has risk exposure to lower prices should have a hedge position with a negative delta. For those who are short in the cash market and at risk to higher prices, a hedge should have a positive delta.
In terms of hedge placement, a strict policy will align hedge maturities as closely as possible to anticipated purchases and sales in the cash market. While more liberal policies may relax this to some extent, rules should be in place to help guide the process. Examples might include defining how far apart in maturity or expiration a hedge contract can be relative to the risk exposure in the cash market. Another might be stipulating a maximum size (typically less than 100%) that can be front or back-loaded if this practice will be included in the policy. A thoughtful policy and approach can help better define the shades of grey and make sure that a hedge doesn’t become too speculative and limit the effectiveness of one’s hedging program.
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