Options, futures or forward contracts? Two farmers search for sustainable income
Dennis Pashovitz calls it his ’67 Cougar moment. It was the late 1990s and the grain farmer at Arelee, an hour west of Saskatoon, needed cash to open a trading account. The only way to learn about marketing, he was convinced, was to play with real money.
So his pet car had to go, and with the $3,500 he got for it he was soon buying and selling futures. And at first, it actually seemed to work; he was turning small, lower-risk trades and in the process making some money in bits and pieces. In fact, maybe it was too easy, because then he started taking bigger, more speculative risks.
By now, every farmer across the country knows how the story ends — no car, and no money to show for it. Pashovitz soon lost all of the funds. But in retrospect, it was a small price to pay for the lessons he gained about market trends and about using options and futures to hedge risk.
Importantly, he also learned to not move too far away from the initial plan, and to pay more attention.
The lessons stung, and they stuck. For the next several years, he shied away from trading but slowly built up the confidence to try again by watching the market trends. He became familiar with market patterns and how to interpret charts, and he got an idea how to read where the market was heading and the common ranges for trading.
And he learned how volatility can be a good way to make money with options. “The best things are often not the smoothest,” he says.
In Ontario, meanwhile, Dale Mountjoy still flinches when anyone mentions the year 1992. It was in that year, after all, that Mountjoy, who farms just north of Uxbridge, Ont., was one of the many farmers in his area who struggled between deluges of rain to grow and harvest a crop. Then, of course, corn prices tanked.
It took two years and some family equity help for Mountjoy to recover, and he remembers he was one of the lucky ones who managed to stay afloat. “It was well into 1994 until we got things turned around,” he says. “I know some who didn’t make it.”
Those life-sucking prices and demoralizing weather conditions taught him some flinty lessons in resilience, risk management and marketing. Hedging made sense but he needed to learn more, like how to manage market risk and how transaction costs can erode slim margins.
“In my experience, rolling should only be used for crops planted in the ground,” he says. “Every time we rolled a contract it ate into the profits again and again and again,”
Today, Mountjoy, his wife Carlene, and daughter and husband, Holly and Owen Boucher, grow about 1,600 acres of corn, wheat and soybeans, operate a Pioneer seed dealership, and have a 60-cow purebred Angus herd. A few years ago they also moved from the shadow of urban development to another family farm about an hour north.
There were also market wins he says, remembering 1996 and 2008 when he rode the market and booked in his best gross revenues ever with a combination of direct sales and forward contracts.
However, those cruel ’92 lessons still underline his marketing plan. They’ve become his starting point.
CFO and bookkeeper Carlene keeps a close eye on cash-flow statements. Knowing their farm’s accrual financial situation and cash flow demands is the first step in setting a marketing plan. Sometimes the reality of farming doesn’t always allow you to follow the best advice, says Mountjoy, adding he is not a marketing expert but has learned some lessons along the way.
“You really have to know your real cost of production, including wages, the cost of your pickup, liability insurance, all of it,” he says. “Knowing our cash-flow demand for the year is the best reality marketing tool.”
In 2003, the couple took CTEAM and still credit the course for teaching them how to use their financial numbers to create a realistic and disciplined profit-based, marketing plan for their business. “CTEAM is the best thing we ever did for our farm, and for ourselves,” says Mountjoy. “It gave use perspective of our overall finances and showed us how much of an impact marketing can have.”
Mountjoy says it helps to take marketing courses at least every five years to reboot his marketing enthusiasm. Now his daughter and son-in-law are starting to familiarize themselves with marketing terminology and strategies.
Mountjoy is still part of a bi-weekly marketing call with CTEAM’s president and former professor at the University of Guelph, Larry Martin. Although he tries to follow movements in the corn and soybean markets daily, this dedicated marketing phone call ensures he brings his mind back to the task of marketing every two weeks, even during busy production periods.
This has proven especially useful since recent springs have produced some of the year’s best prices. Following this trend, Mountjoy tries to do more marketing during May even though they’re busy getting crop in the ground.
Mountjoy likes to forward contract for 60 to 70 per cent of his production by July and uses crop insurance. In the past, he has tried buying options, booking futures contracts and occasionally booking basis, which all have worked — sometimes. However, he’s come to prefer the simplicity of watching the market for profit-taking opportunities and signing forward contracts.
“If we are on the positive side, I take it. You still have to pull the trigger, whether you are buying and selling pulls and calls or booking a forward contract. With the other ways to hedge, I just had a little longer time to market.”
In the last decade or so, more smaller, mostly farmer–owned elevators have popped up in Mountjoy’s area and he figures the number of grain companies he can deliver to has increased from one to half a dozen. He tries to stay connected to most of them, looking for selling opportunities and building relationships.
This is especially important to him, as their farm doesn’t have any storage. “I’ve never owned any storage so I tend to contract,” he says. “At least up to crop insurance values.”
The problem with a forward contract is you lock in at a certain amount and if a terrible weather season happens, there may not be enough volume or the right quality to deliver. To counter this very real possibility, many farmers only forward contract to their crop insurance yields.
Forward contracts can have a futures hedge already priced into them as the grain company likely did some futures trading before offering any forward contracts to farmers.
Mountjoy remembers in the early ’90s booking an $8 soybeans forward contract and how satisfying it was to fill this lucrative contract when prices dropped. He remembers the most recent market missteps more vividly: last year the markets went sideways for so long Mountjoy was lulled into inaction so didn’t book enough forward contracts early enough before prices dropped.
Mountjoy was active in leading the amalgamation of the corn, soybean and wheat growers associations in Ontario to become the GFO — Grain Farmers of Ontario. Both GFO and G3 Canada Limited, (the company replacing the CWB), offer a form of pooled pricing. Other grain companies may also offer pooled pricing. “Markets have found there’s still a percentage of farmers who want to pool price,” says Mountjoy.
Pool pricing is the average market price of a crop over a period of time, several weeks, months or a year’s worth of market sales activities, as compared to the price risk inherent in fixing a price on a given day. These pools are different for grades and other quality factors like protein, which some years can be quite volatile and unpredictable.
Mountjoy isn’t satisfied with a pool price for grains, although he understands why some farmers resort to this marketing, especially if the farm’s primary enterprise is intensive livestock production, like dairy. “It’s always a challenge to balance the demands and fluctuations of production with marketing,” he says.
CTEAM’s Larry Martin says the right tool for hedging depends on what a person is trying to achieve. “If your objective is to lock in a certain price and the market offers that on a forward contract, why go through the hassles of hedging with options?”
The basic difference between forward and futures contracts is futures are traded on an exchange but a forward contract is privately negotiated with specific companies. The cost of production plus profit should be the number you know when booking a forward contract.
When booking futures contracts you’re trying to book the highest price you can from the market, says Martin. He looks for resistance plateaus that usually indicate it might soon be time to sell or buy. “Marketing a crop without a chart is like trying to drive to a new place without a GPS,” he says.
Martin suggests if you’re going to hedge grain prices on the futures markets, you may also want to hedge exchange rate. To do this you need a currency trading account with a broker who would buy a contract for a predetermined amount of currency at a known rate within a specific time frame. Having this currency means you don’t have to use spot currency trades so you aren’t forced to purchase or sell currency at any rate.
The certainty of knowing your exchange rate in advance can be critical in maintaining profitability, especially for some crops and livestock. “Wheat has more of foreign currency component to it than some of the others,” says Jonathon Driedger, senior market analyst with Farm Link Marketing Solutions based in Winnipeg.
It takes more technical analysis to try to do futures trading, says Martin. “I strongly believe that to trade futures you must have strict rules about when to get in and out,” he says.
The lesson — “discipline”
Pashovitz uses several hedging strategies with the help from hired advisers at Farm Link Marketing Solutions and his trading broker. “Having good information makes for good marketing decisions,” he says.
Every time he’s going to make a sale or a trade, he first checks in with these advisers. Pashovitz remembers one year calling his Farm Link analyst to tell him he was considering buying a $6.30/bu. wheat contract and he told him about one for $7/bu.
Although they are not 100 per cent right all the time, he values the return on investment in marketing advice as an essential part of his farm. “In one year they saved me more than $300,000. We forward priced aggressively on their advice and it paid huge dividends,” says Pashovitz.
Marketing takes extra work, talking to the right people, but it helps to maximize the potential of the markets, he says. “I’m young and still establishing, I need to maximize the dollars I get from my crop. I need to up my game.”
This spring, Pashovitz and his wife Karen seeded 7,500 acres of wheat, canola, lentils, oats and barley. This past year they sold about a third off combine, a third of the crop is in the bin and a third in bag storage.
Like the Mountjoys the Pashovitzes start with a marketing plan based on costs of production and the farm’s cash-flow needs. Throughout the year Dennis and his marketing adviser use and review the marketing plan to see what’s changed.
“All my trades are backed by grain; they are not unprotected,” he says.
Of all his crops, he says lentils have been the most challenging lately to market because price depends on one country and its political situation. There’s no exchange for lentils so they used stored lentils until the price was acceptable and then sold them. They might have to revisit that strategy.
He says stored grain is no different than a long futures contract. “Every farmer is long on grain in the bin.”
Pashovitz employs several hedging strategies using options, usually covering about half of the crop’s potential yield with a paper trade, buying and selling futures contracts or buying and selling puts and calls.
A few years ago, Farm Link took some of their clients on a tour and course at the CME, including Pashovitz. The brokers taught them various strategies and there’s a marketing strategy for almost every situation. He also learned how important it is to understand how time plays into the markets. “With trading you can go broke being right too early,” he says.
Canola prices tend to typically trend higher in March so Pashovitz will wait until March to sell physical crop. In the meantime, he might buy puts and calls options to cover pricing opportunities along the way on the up and down sides. “Between September (harvest) and March, nine-tenths of the time prices will increase,” he says.
If you’re trading futures, you need to ensure there’s enough money in the account to cover the margin calls and you have to pay attention in case they need to be liquidated. “If you’re going to play with contracts, you need access to enough cash,” says Pashovitz.
In retrospect, a pivotal lesson he has learned was if you’re truly hedging, your trading account doesn’t always have to make money. If the price goes up, you might lose on your hedge, but don’t forget your inventory is worth more, likely a lot more, so you’ve made money overall, says Pashovitz.
A call essentially gives you the right to buy the underlying commodity at a specific predetermined “strike” price any time within a certain period before it expires.
Put options work the same, but for the opposite price direction. So if the price of a commodity falls, a put gives you the right to sell at a strike price before expiration.
The trouble with trading options is they’re sometimes not worth the expense, says Pashovitz. So instead he sometimes tries to “cheapen” them by buying a put right close to the strike price so it pays quickly. He then sells a put further away from the strike price. Selling a put gives him money to “cheapen” the trade. The trade pays almost immediately but profit is limited to the range between the put he bought and the put he sold.
One strategy Pashovitz uses is to watch for bottom pricing opportunities and buy put options to sell at the bottom, and then wait for it to come up again to sell any physical grain. The put option sale helps with cash-flow and hedges a floor price.
Buying options to hedge is more like price insurance. Larry Martin’s rule for trading options is once put prices hit three per cent below strike price, you should consider selling it. “At three per cent it’s still pretty cheap insurance,” he says.