How to use grain futures and options to manage risk
© FW Murnau and Fox Film Grain futures and options provide a way of managing volatile grain markets, but understanding how they work is critical to using them successfully.
The futures market is a formal, regulated forward market for commodities, where set tonnages of a standard quality are traded for delivery at set times to a nominated futures store.
In practice, physical delivery takes place relatively rarely because buyers’ and sellers’ contracts are matched, effectively cancelling each other out.
Through hedging or risk management, futures and options can help protect from unfavourable price movements.
See also: BPS – advice on 2023 claims as delinked payments near
“What’s great about the futures market is that it keeps transparency in grain prices so no one can be misled,” says AHDB analyst Anthony Speight.
Wheat futures
UK wheat futures contracts are traded through ICE Futures Europe for January, March, May, July and November, which is the main contract in volume terms.
Ten contracts are open for trading at any one time, so wheat can be hedged through to January 2025.
UK futures contracts are traded in lots of 100t, with a £4,021 initial margin to be deposited for each lot by users of the market.
Further cash is required to fund margin calls, which occur when the market moves against an open futures position.
Paris wheat futures are traded through Euronext and are based on a continental milling-grade wheat, traded in 50t lots and requiring a €2,188 (£1,750) initial margin.
The UK wheat futures price is equivalent to a physical ex-store price, loaded on to a buyer’s lorry from a registered UK futures store.
The difference between ex-farm and futures prices, usually a discount, is known as the basis.
The level of basis depends on the physical supply-and-demand balance for a given season and region.
However, in areas such as Yorkshire, where industrial demand is strong, the physical price is often higher than the futures price.
To protect the value of income from physical grain sales, a counterbalancing futures contract can be bought.
A grower who wants to hold on to physical grain would typically sell futures, while those selling grain would buy futures to hedge against a price rise.
Futures example
- A grower budgeting to receive £220/t for his wheat might sell November wheat futures for £225/t to secure a price cover
- They retain the grain in case of a price rise
- If the physical market falls by £10/t, they get £210/t for their grain
- In this case, they would buy back a futures contract for £215/t, giving £10 profit on the futures transaction
- They have achieved a net price of £220/t for their grain
- If the market rises, they gain on physical grain sale, but must buy a higher priced futures contract to close out their obligation to deliver the first futures contract they sold
Cash deposits and margin calls
Trading futures on an exchange requires an initial cash deposit to be put up to cover market movements against a futures position.
Once those funds drop to a certain level, further calls for cash, known as margin calls, are made to cover the loss.
The London wheat futures contract is relatively illiquid and trades in lower volumes than other exchanges.
The milling wheat contract on the Paris Euronext market is more liquid and is attractive to users despite the added exchange rate risk.
Farmer futures user
Pete Collins of MJ & SC Collins on the Essex/Hertfordshire border prefers futures to options to protect returns on combinable crops.
His key advice is to know the market and understand the technical detail of how the tools work.
“A clear plan is needed, with solid workings on position sizing relating to the grower’s physical production, says Mr Collins, adding that a futures position must be actively tracked and managed.
“I would encourage people to always have a solid reason for entering the market. Ours include cashflow.
“For example, if our business requires payment for grain, but we feel the market is set to rise, we would sell physical crop, take the income, then enter a long [bought] futures position.
“The other time I often use the futures market is when the physical buyers’ basis is not competitive.
“When the market moves very fast in a short time, we have noticed that physical buyers are less competitive, even up to £15 off the futures.
“In this instance, I would sell the tonnage we wanted to sell but using the futures market by opening a short position [selling futures contracts].”
Options
Options are a form of price insurance which, unlike futures, do not incur margin calls.
They give the buyer the right, but not the obligation, to buy or sell a futures contract at a set price. A premium is paid for the option, which is effectively an insurance policy.
There are two types of option:
- A “put” option gives the right to sell a futures contract at a set price, protecting a minimum price for unsold grain
- A “call” option (the right to buy futures at a set price) can be used following a physical grain sale to benefit from market rises.
The cost of options depends on the length of time the option has to run, the price at which it is set (the “strike” price) and market volatility.
For example, on 30 January, an option to buy London November 2023 feed wheat futures at £221/t would have cost about £20/t.
“Using options gives farmers the ability to trade in confidence – for example, to sell forward safe in the knowledge that they will gain if the market rises, but also having the peace of mind in a minimum price,” says Mr Speight.
Options example
- November 2023 wheat futures are at £225/t
- Farmer’s ex-farm basis is -£5/t – an ex-farm equivalent of £220/t
- Grower sells physical grain forward for November 2023 at £220/t
- Grower also buys November 2023 call option with £225/t strike price, costing £20/t
- Grower has set an absolute minimum price of £200/t – the £220/t ex-farm sale, less £20/t option premium
- Market falls £50/t, taking futures to £175/t (ex-farm equivalent £170/t), previous £220/t ex-farm sale remains in place
- Call option premium of £20/t has been paid, but option does not pay out because market has fallen – grower achieves minimum price of £200/t
- If the market rises £50/t, taking futures to £275/t (ex-farm equivalent £270/t), the previous £220/t ex-farm sale remains
- Call option premium of £20/t has been paid; option pays out £50/t – difference between option strike price of £225 and current futures price of £275/t, so the grower achieves £250/t, comprising £220/t ex-farm sale, less £20/t option premium plus £50/t option payout
Futures or options?
Products traded directly through brokers who are full members of futures exchanges such as London’s ICE Futures Europe or Euronext Paris are heavily regulated, offering protection to users.
Increasingly stringent financial regulation means that access to brokers is narrowing for smaller investors unless they can demonstrate suitable experience and expertise as well as substantial cash funds and assets.
As a result, relatively few brokers will handle retail or individual accounts, such as those likely to be run by farmers.
Those who want to use futures or options need to have a basic understanding of what each tool does, and to understand the different ways of accessing these markets, says James Bolesworth, managing director of grain trading adviser and analyst CRM AgriCommodities.
Some merchants and co-ops provide options-linked contracts for farmers. These rely on good relationships between farmer and merchant, he says.
Such contracts are over-the-counter products and so do not have the backing of the Financial Services Compensation Scheme.
Growers who use them need to check the price of the option against similar exchange-traded option prices, to make sure they are on the right lines in terms of cost, Mr Bolesworth advises
Farmer options user
Dan Wormell of PR Wormell Farms near Colchester in Essex sells about 80% of his grain at harvest to aid cashflow and reduce the risk associated with storing grain.
He has used Euronext options in some of the past five years to protect from a rise in the market following his physical sale.
“To be fair, it’s a steep learning curve. You have to be prepared to put the work in and understand the tools available,” says Mr Wormell, who has 600ha of combinable crops.
“We’ve also used futures in the past, but it’s not for the faint-hearted. Options can look expensive, but we’re not necessarily looking to protect against a £10/t movement. If we have another world supply issue and the market is going to move £50/t, that can put it into perspective.”