To illustrate how a farmer might use the commodity market as a hedge

  To illustrate how a farmer might use the commodity market as a hedge. A farmer has estimated that it will cost $2.00 to grow a bushel of corn and he wants 20% profit at harvest time. Therefore, the farmer needs $2.40 a bushel. If the current cash price for corn is $2.40 he could sell one or more contracts of corn for delivery in December for $2.40 / bushel.

  One standard contract of corn = 5000 bushels. $2.40 x 5000 $12,000. Rarely will they sell contracts against their entire crop because the crop yield is unknown.

  Follow this scenario. The price of corn at harvest has dropped to$2.20 a bushel. (Remember the farmer needs $2.40 p/ bushel.)

  First, the farmer sells his crop for $2.20 a bushel. Second, the farmer buys back the futures contracts for $2.20 for a gain or 20 cents. The math works out like this:

  Sold Futures Contract $2.40 p/bu Offsets Position (Bought Back) $2.20 Gain $0.20 Sells corn crop to grain elevator $2.20 Total proceeds form crops and 'Hedge' $2.40 ($2.20 + .20)

  The farmer gets the price he/she needed by using the commodity markets as a hedge against lower crop prices to realize a 20% profit.

  Here is how it would have worked out had corn prices increased. For our example let's say corn prices increased to $2.55 at harvest. Great news for the farmer. Right? Not necessarily. The farmer gave up future profit to be assured of a known profit at harvest time

  Sold futures contract (Hedge) $2.40 Offset position (Bought back contracts) $2.55 Loss -$0.15 Sells corn crop to grain elevator $2.55 p/bu Total proceeds from crops and 'Hedge' $2.40 ($2.55 - .15)

  As you can see the farmer still realizes a crop price of $2.40. It's actually a little more complicated than that but it should give you some idea of how the commodity markets work for producers. The end users use the hedge in much the same way.

  The other players in the commodities markets are the speculators.

  The large speculators.

  These are mainly the large commodity pools, similar to a stock market mutual fund. The pool managers will buy and sell large numbers of commodity contracts in an effort to make a profit for their investors.

  The small speculators, that's us.

  We buy and sell futures contracts based on fundamental and technical analysis of a market trying to determine where a particular market price will be at some point in the future.

  Speculators Provide Liquidity.

  The farmer wants the highest price possible and the giants like the breakfast cereal makers want the lowest price possible. The Hedgers are in the market for the long haul, several months to sometimes a year or more. They are in effect putting their risk of future price fluctuations on the open market for someone to assume. Without price movement provided by speculators the hedgers would soon reach an impasse on price.

  Speculators assume that risk and provide the necessary liquidity to the market place thereby keeping the producers and manufactures from reaching an impasse on price. We, and the large commodity pool managers, are looking for profit on a much shorter time frame and are willing to assume the hedger's risk thereby providing liquidity, (buying and selling) that creates the necessary price movement.


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