The price you keep after a short hedge is the futures price you locked plus your basis, the gap between the exchange quote and what your local buyer pays. For a farm far from the contract’s delivery point, the basis is usually a negative number. Lock 12.00 a unit against an expected basis of 1.20 under, and the hedged part of your crop brings 10.80 at delivery, as long as the basis comes in where you expected. Before you hedge, work that price out on paper next to your cost of production, and decide from it how much of the crop to cover.
These figures are a worked example, per unit of whatever you sell (bushel, tonne or bag) in the contract’s currency, not a market quote. In the hedging scenario calculator you enter the same two numbers and get 10.80 back, not the 12.00 on the screen.
What you end up with is a hedge sheet, one page on paper or in a spreadsheet. On it go the effective price, the worst basis your costs can take, the share of the crop you hedge and why, and the cash set aside for margin. It is worth filling in before a broker calls, because during the call the futures quote tends to be the only number on the screen, and the basis is not on it.
Why is the locked price not the price you keep?
Because the futures contract is priced at a delivery point that is not yours, and the gap between the two is the basis. In a guide to basis for Kansas State University extension, Dhuyvetter writes it in one line: “Cash Price - Futures Price = Basis”, taken at the same moment. Kansas State is explicit about the sign: “A negative basis implies the futures price is greater than the cash price, and a positive basis implies the futures price is less than the cash price”. Freight, handling, storage, quality and local supply open that gap, which is why a farm far from the delivery point usually sees a basis under the futures.
The sign is only half of it. What matters is how today’s basis compares with the usual basis for your place at that time of year. Kansas State calls a basis above normal strong and one below normal weak, and explains both: “When the grain basis is stronger or narrower than normal, the market is providing a financial incentive to make cash sales”, while a wide or weak basis is discouraging cash sales and encouraging storage. Brokers use the same words on the phone, and a weak basis is the usual argument for storing and selling later.
The hedge is a position on the exchange that moves against your grain. You sell futures now and buy them back when you sell the grain, so if prices fall, the grain loses value and the futures position gains about the same amount. CME Group puts the result plainly in its self-study guide for hedgers: “Once you establish a hedge, the futures price level is locked in. The only variable is basis.”
Run the numbers once. If the local price at delivery is 15.00 and the basis came in at 1.20 under, futures are at 16.20, so buying them back costs 4.20 more than you sold them for, and 15.00 minus 4.20 is 10.80. If the local price is 9.00, futures are at 10.20, the position gains 1.80, and 9.00 plus 1.80 is 10.80 again.
What does a partial hedge do to the range of prices you receive?
It narrows it, and you can see by how much in a table of possible prices at delivery. Each row below is one local price at delivery. Next to it is what you receive with no hedge, and what you receive on average with 600 of 1,000 units hedged at a locked 12.00 and an expected basis of 1.20 under.
| Local price at delivery | No hedge | With 600 of 1,000 hedged |
|---|---|---|
| 9.00 | 9.00 | 10.08 |
| 10.50 | 10.50 | 10.68 |
| 12.00 | 12.00 | 11.28 |
| 13.50 | 13.50 | 11.88 |
| 15.00 | 15.00 | 12.48 |
Rurivia calculation from the worked example: the 600 hedged units bring 10.80 each, the 400 unhedged units bring the local price of the day, and the last column is the average of the two.
Without the hedge, what you receive spans 6.00, from 9.00 to 15.00. With 60 percent hedged it spans 2.40, from 10.08 to 12.48, which is 60 percent narrower. The same holds for any share up to the whole crop, because only the unhedged part still moves with the market: hedge half and the range halves, hedge everything and only the basis is left to move.
From the two ends of the table you get the cost of that protection, and both are known before you sign. In the best case the hedge cost 2.52 a unit, 15.00 against 12.48. In the worst case it earned 1.08 a unit, 10.08 against 9.00. With the hedge you buy a narrower range of income, and the gain you give up in a rally is what you pay for it.
What risk is left after you lock the price?
The basis. CME Group, the Chicago exchange, states the trade in one sentence: “By hedging with futures, buyers and sellers are eliminating futures price level risk and assuming basis level risk”. The 10.80 in the example rests on a basis of 1.20 under, and nothing guarantees it. If the basis comes in at 1.60 under, the effective price drops to 10.40, which is 0.40 a unit and 240 on the 600 hedged units. Only the hedged units carry that risk, because the unhedged ones are sold at the local price of the day, which already includes whatever basis turned up.
The trade usually pays because the basis moves less than the price. Kansas State says basis levels generally can be predicted with more accuracy than either futures or cash price levels, and shows it with wheat at Dodge City, Kansas, from June to December of 1987 and of 1989: an average difference of $1.42 per bushel in price levels between the two years, but only a $0.17 per bushel average difference in basis.
A narrower range is worth most to a farmer with commitments that cannot move in date or amount: a fixed loan payment, cash that will not last through a bad quarter, inputs already bought at a set price. For that farmer, a slightly lower average price with a known floor beats a higher average that can fall below cost. With cash to spare, little debt and freedom to choose the month you sell, the same protection gives up gains for little use, and the decision not to hedge goes on the hedge sheet too.
Where does the expected basis come from?
From a historical average, which makes it a forecast. Kansas State describes the practice and its limit together: “This year-to-year stability in basis means that historical basis patterns are useful in forecasting future basis levels”, usually as an average of the last three to five years, adjusted for current conditions. Kansas State also warns that cash and futures can move in opposite directions for short periods, and in those weeks an average helps least.
The average has to line up by week of the year. The guide’s example is the “5-year average weekly basis (Wednesday’s cash and futures prices) for soybeans in Topeka, Kansas”: each week of the year averaged across five years, at the same delivery point and against the same contract month. That matters because the basis at one place changes through the year, and in the guide’s wheat example “basis became more negative as the 1990 wheat harvest got underway”. An average of the last few weeks gives you the basis of now, not the basis of your delivery week.
If you have only a year or two of your own prices, average the most recent weeks you have and treat the result as a starting point until you have three to five years for the same week. Those years come from a price record with a source, a weekly log of your buyer’s bid, the futures quote and the gap between them, which has its own article. Write the expected basis with the date, the place and the contract month it came from, because a basis borrowed from another delivery point or another month is a different number under the same name.
Adjusting for current conditions fits on one line, because the basis reflects local supply and demand for a commodity relative to the futures market. A local crop bigger than the ones in the average means writing the basis further under, with the size of the adjustment and the reason next to it.
How bad can the basis get before the hedge stops covering your costs?
Start from your floor, the lowest price you can take, which is usually your break-even price, what the crop cost per unit, worked out in its own article. Say it is 9.90. The break-even basis is that floor minus the locked futures price: 9.90 minus 12.00 is minus 2.10, or 2.10 under. If the basis comes in worse than that, the hedged units bring less than they cost. With an expected basis of 1.20 under, you have 0.90 a unit of room.
Write the break-even basis and the expected basis side by side, with their signs, and remember that the room applies to the hedged units only. The unhedged units keep moving with the market, so in a bad market your average can fall below 9.90 even if the basis comes in exactly as expected. Whether you can live with the position depends on that room more than on the expected basis alone.
Why does hedging more than you grow stop being protection?
Nobody does it on purpose, but two ordinary things lead there. Contracts come in fixed sizes, and for corn CME Group notes that “each contract equals 5,000 bushels”, so the hedged quantity jumps rather than moving smoothly, and rounding up one contract on a small crop can take you past your expected production. The other is a short harvest: a position sized for the yield you expected covers more than the yield you got. The fix is arithmetic: compare the hedged quantity with the production estimate every time the estimate changes.
Past that point, the unhedged share turns negative and the effect flips, so each rise in the market lowers the price you keep. Hedge 1,500 units against an expected 1,000 with the same 12.00 and 1.20 under, and you average 11.70 a unit if the market ends at 9.00 and 8.70 if it ends at 15.00. That position gains when the market falls and loses when it rises, on grain you do not have, which makes it a bet against the market. In the calculator, entering more than your expected production brings up a warning, and above that point the “swing taken out” figure no longer measures protection.
What cash does the hedge need before delivery?
A hedge needs money in the months before it pays anything, and the call for it comes when prices are rising. CME Group describes the mechanism: “if a change in the futures price results in a loss on an open futures position from one day to the next, funds will be withdrawn from the customer’s margin account to cover the loss”, and topping the account back up is what the industry calls meeting a margin call.
A short hedge loses on the futures side when prices rise. The rally that makes your grain worth more is the same rally that pulls cash out of the margin account every day, and the gain on the grain arrives only at delivery, months later. You can be protected on price and still run short of cash. With the calculator you get the price at delivery, not the cash needed along the way. Ask the broker for the margin per contract before signing, and set aside cash for a move against the position as large as the market has made before.
How much of the crop should you hedge, and against what?
Against the price the crop has to reach, not against a view of the market. The share comes from the smallest of three limits.
The floor is a yes-or-no test. The effective price of the hedged units is 10.80 whether you hedge 10 percent or 100 percent of the crop, so this test only settles whether there is a share at all. In the example, 10.80 clears the 9.90 floor. If it did not, the share would be zero, because a hedge that locks a price below cost removes the uncertainty about a loss, which is rarely what anyone intended.
The physical ceiling is the production you are sure of, not the production you expect. The pessimistic estimate belongs here, because it survives a short harvest, and hedging above it is hedging more than you grow.
The financial ceiling is the cash you can keep sending to the margin account while the market rises. A position you cannot carry to delivery gets closed at the worst moment, with the futures loss already paid and the gain still in the field. The share is the smallest of the three numbers, and the reason it is that one goes next to it on the hedge sheet.
The trade calls that share the hedge ratio, here simply the quantity hedged divided by expected production. Statistical methods that estimate an optimal ratio exist, but they need years of your own cash and futures prices at your delivery point.
Farmers can also misjudge how far prices move. Most of the 90 maize growers that Cruz Júnior and colleagues surveyed in Brazil in 2008, in a peer-reviewed study, held a perception of risk below the risk of the market, a finding from one country and one crop. Anyone who believes prices move less than they do will honestly conclude that less cover is needed.
Write the share and the reason on the hedge sheet, because by next year the reason is the part that gets forgotten. Also write down the grain already sold under contract, the volume already priced, which is your running count of grain sold ahead. It comes off the same production you are about to hedge, and counting those units twice is the usual way to end up hedging more than you grow.
Sometimes the right share is zero even when the price clears the floor, and one of three conditions is enough. The basis has never been measured at your delivery point, so the effective price is a guess with two decimals. This year’s production is still too uncertain for a physical ceiling, which is common before the crop is made. Or there is no cash set aside for a long rally, so the hedge can end in a forced close of the position. All three are fixed by work, not by reading the market.
Two nearby decisions have their own articles. One is whether it is worth waiting to sell, which weighs storage against today’s bid. The other applies if what you hold is a forward offer from a buyer rather than a futures position. There the basis comes already set in the bid, a number you take or leave, and the article on whether locking the price now is worth what it costs works through that case.
Where to start
An hour with your price record, the futures quote and your cost of production, before the broker calls.
The blank line at the bottom is the one that pays off. Fill it in at delivery and you will see how far the real basis landed from the one you expected; after a few seasons, your expected basis comes from your own record instead of a borrowed average.
That line, the gap between the exchange quote and your own buyer’s bid on delivery day, is a piece of marketing no one else can keep for you. In farm management, a record like this is what the other decisions on the farm draw on.