Alabama A&M University
S M A L L FA R M S R E S E A R C H C E N T E R
FA C T S H E E T
COLLEGE OF
AGRICULTURAL, LIFE
AND NATURAL SCIENCES
United States Department of Agriculture
Office of Advocacy and Outreach (OAO)
Price “It’s What You Make It”
One word probably comes to mind when most farmers are asked about risk: debt. A financial
crisis occurs when you can’t pay off the money borrowed to buy land, machinery, and crop
inputs. It is even possible ten years later, bankruptcy, foreclosure, and the loss of the family
farm remain powerful indications of the risks of leverage. Along with these factors, price risk
is another big threat to the producer’s business income and stability.
Farmers with little debt and strong earnings can better
afford to take a lot of price risk. In the event that prices
do fall, they’ve got more than enough money to put in
another crop and do it again. By taking substantial
price risk they may increase the ultimate rewards they
coax from the market. However, some farmers don’t
have the luxury of waiting for the market. Uncertainty
of the weather and debt is all the risk they can afford to take. Fortunately, forward a cash
contracting, buying a put option, minimizing price contract, hedging to arrive, selling futures
and storage are tools used to reduce price risk.
Forward Cash Contract
Forward cash contract is also known as fixed or flat price contract. This is an agreement
where you lock in a final price for a commodity you’re either storing or expecting to rise. For
example, the commodity that’s growing in the field can be locked in at a good price as a rally
from a summertime weather scare. On another note, you can forward contract stored inventory, using a post-harvest rally to price the crop you’ll store until the river system opens.
Buying A Put Option
For as many as 19 years, farmers have been trading options on commodity futures Agriculture options convey the right to buy or sell a specific futures contract at a set “strike” price.
This is where the buyer of an option pays the seller a fee or premium in exchange for that
right. Agriculture options have different expiration dates. For instance, the expiration dates
expire a week or two before the beginning of the delivery month for the futures contract involved.
Small Farms Research Center
Alabama A&M University
4900 Meridian Street
James I. Dawson Building
RM #219
P.O. Box 700
Normal, AL 35762
It is important for one to understand exactly what a put option is. A put option is usually the
opposite of a call. The option to sell futures is the put option. This simply means the right to
sell a specified futures contract at a specific strike price. For instance, if futures are higher
than the price, the put is “out of the money” and not worth much. If futures are lower than
the puts strike price, the put is “in the money” and worth much more because it could be exercised and the resulting futures position closed out an immediate profit, which works best in
the producer’s favor.
Minimum Price Contract
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
Whenever you sell grain to a buyer, for a fixed price, less the cost of a call option you chose,
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this is usually called a minimum price contract. In the event that price increase, there is a possibility that one can
add to the selling price. In the same token, in the event that the market price does not rise, you are guaranteed the
minimum price.
One positive thing about this is the price can be used both before and after harvest. The specific details in the contract varies. For example, some elevators allow you to sell the option and fix your price at any time, while others
require holding the option until expiration. Some of these contracts fix the basis, while others combine the call with
a hedge-to-arrive. Although most farmers still prefer to buy options through a broker, these option-derived cash
contracts have carved out a niche.
Hedging –To-Arrive
There can be a lot of flexibility in hedging. These cash contracts are used to adjust the futures portion of your price,
but allow you to identify the basis later. For example, you can close out a sale in one futures contract month and
then sell again in another month. This is one way of seeking additional basis gains and to profit on the spread, or
difference, between futures contract months.
However, there is danger in doing this if there is too much flexibility. One example would be if the spreads between old and new crop futures soared twice as high as ever before, hedge-to arrive contracts can cause high looses for farmers who price two years of a crop based on the previous year’s crop futures. Case in point, if a crop for
2003 and 2004 is priced based on the crop futures of 2002, a hedge-to arrive can cause a great loss for that producer. Since this has been such a big problem many elevators have been forced to institute striker controls over
their hedge-to-arrive contracts. The rolls are limited to the same crop year as the original hedge and if the futures
prices increase, you may have to pay the elevator the equivalent of margin money which is not good for the
producer.
Sell Future
There is one disadvantage in fixing futures and basis. This drawback is that futures and cash markets are not
always strong at the same time because basis change. The cost of storing a commodity until the delivery period
and transporting it to the delivery site set by the futures contract is reflected when the basis changes. Then demand
kicks in because the more customers need the crop, the more they’re willing to pay for it, strengthening the cash
market and the basis. On the other hand, when you have more of a commodity than you need, storage and transportation costs increase, and supply overwhelms the demand causing the basis to weaken.
By selling exchange traded futures contracts directly through a broker, it helps
you fix the futures and basis parts of your price at different times, giving you a
higher overall price.
The delivery month and the quantity of a commodity are listed on a futures
contract. Buyers and sellers of grain, for example, use the contracts as surrogates to lock in a price for the commodity. This is later offset by the seller after he buys back the previous sale. After this happens he adds or subtract
any profits or losses from the price they negotiate in the cash market.
Using futures directly, however, gives a producer more flexibility than cash instruments. Storing after harvest
while waiting for basis to strengthen, will allow you to sell your futures in the spring or summer rallies. Then buy
back the position later when prices are lower. One good thing is that you will have he freedom to wait for a cash
market rally or to hedge again in a contract month for later delivery.
Selling with a cash contract commits you to delivering the commodity. In the event that your yields come up short,
you have the option to cancel the contract as easily as you can with a futures position
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One of the most basic risk management tools on your farm is your grain bin. This gives you the option to hold
your grain until prices are higher and prevents you from having to sell your grain off the combine when prices
are at their lowest. By being able to sell a little of your crop throughout the year increases the chances of getting
an average price. This is a very powerful risk management strategy.
The disadvantage to storing is the cost, no matter if the storage is on farm or in the elevator in town. Unfortunately, some years prices don’t rally after harvest, and often the best prices of the year come during the growing season. However, another advantage is the possibility of USDA offering financial assistance for construction of storage bins.
This information was complied from the USDA Risk Management Agency.
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Small Farms Research Center
The Small Farms Research center at Alabama A & M University (AAMU) was first conceived in 2000 with
funding from USDA’s Office of Outreach authorized under section 2501 of the 1990 Farm Bill. The mission
of the center and the Small Farmers Outreach and Technical Assistance Program is to assist all small and limited
resources farmers effectively deal with agricultural risk, food safety, and overall farm management issues and
provide them with information.
Learn more about us by visiting our website and Facebook page through the link below
Website
http://www.aamu.edu/sfrc
Facebook
http://www.facebook.com/smallfarmsresearchcenter
Contact Information
Dr. Duncan M. Chembezi
Director & Professor
(256) 372-4970
Email: duncan.chembezi@aamu.edu
Ms. E’licia L..Chaverest
Program Manager & Marketing Specialist
(256) 372–4958
Email: elicia.chaverest@aamu.edu
Mr. JaMarkus C. Crowell
Program Assistant
(256) 372-4424
Email: jamarkus.crowell@aamu.edu
Ms. Bhargavi K. Pucchakayala
Program Assistant
(256)372-4424
Email: bpucchak@bulldogs.aamu.edu
Cooperating Units: USDA Office of Advocacy and Outreach (OAO), USDA/NIFA/ Beginning
Farmers and Ranchers Development Program (BFRDP), USDA/OAO/Outreach Assistance for
Socially Disadvantaged Farmers and Ranchers (OASDFR) Program, Alabama Cooperative
Extension Systems, and Alabama A&M University.
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