Marketing grain involves two markets. Wrap your head around that concept. Two markets!
Everyone in the USA uses the “cash market” to buy the items for their daily needs of food, gasoline, clothing, etc. A car dealer sells a car and is given money in exchange. That is a “cash market” sale.
There is a “cash market” in the grain business. A farmer delivers grain to the elevator, and he is paid money for that grain. Corn delivered to an ethanol plant is exchanged for money; that is a “cash market” transaction.
When a farmer takes his grain income and buys fertilizer (or anything!) with that money, that is a “cash market” transaction.
Most grain producers only use the “cash market” to market their grain.
However, every successful grain elevator uses the “cash market” and the “futures market.”
Cold, hard cash is the lifeblood of the commodity “futures market”, but it is NOT a cash market!
The “futures market” is a market of contracts, contracts which are bought and sold for:
1) a specific commodity
2) of a specific quality
3) for a specific price
4) for a specific month of delivery
It might be easier to comprehend a futures market contract as a “promise,” a promise by the buyer to take delivery of the physical (cash) commodity and a promise by the seller to make delivery of the physical (cash) commodity at a later (future) date.
In order to trade the futures market, one must have a commodity futures trading account with a brokerage firm.
A futures transaction, just like the cash market, can be a “buy” or a “sell.” The big difference is, one can “sell” a futures contract before he “buys” a futures contract.
Let that sink into your brain-housing group.
You can sell a commodity before you buy a commodity in the futures market.
How is that possible?
The futures market trades (buys and sells) contracts for future delivery. If you sell wheat today (January 14, 2019) in the futures market, you must select which month you are going to sell. If you grow Hard Red Spring Wheat in Montana, you may choose to sell the September 2019 Minneapolis Hard Red Wheat contract. If you sell September Minneapolis Hard Red Wheat futures, you have made a promise (a contract) to deliver a specific number of bushels at a specific price and grade to a Minneapolis Grain Exchange-approved grain warehouse any business day in September 2019.
Let’s say the price of your sale was at the current price of $5.88 per bushel and you sold 10,000 bushels. You now have a contractual obligation to deliver 10,000 bushels of wheat in September 2019 for a price of $5.88 per bushel to a Minneapolis Grain Exchange-approved grain warehouse.
You are now “short” 10,000 bushels of September 2019 Hard Red Spring Wheat at $5.88 in the “futures” market.
“Short” means you have sold before you bought; it means you will make money in the futures market if the futures price goes down.
You expect to grow 10,000 bushels of Hard Red Spring Wheat and sell those 10,000 bushels in the cash market. As of today (January 14, 2019), that wheat, if you grow it, is worth $5.88 per bushel in Minneapolis or $5.88 per bushel plus or minus the basis at the Columbia Grain International Elevator in Harlem, Montana.
The months go by. Now it is late August, 2019, and your 10,000 bushels of Hard Red Spring Wheat are in your farm bin.
Let’s say the Minneapolis 2019 September Hard Red Spring Wheat contract is now trading at $5.10.
What is your cash (physical) wheat worth?
It is worth $5.88 a bushel at the Minneapolis Grain Exchange about 912 miles east of your farm or:
It is worth $5.10 a bushel plus or minus the basis at Columbia International Grain at Harlem, Montana, which is 27 miles away.
Let’s say the basis at Harlem is 20 under the September.
Thus, the cash price of your wheat is:
$5.88 in Minneapolis, 912 miles away or:
$4.90 in Harlem, 27 miles away.
If you deliver the wheat to a Minneapolis Grain Exchange-approved grain warehouse (a grain elevator), you will be paid $5.88 per bushel because, in January 2019, you entered into a contract to deliver 10,000 bushels in September, 2019, and be paid $5.88. That $5.88 will be deposited in your futures trading account upon delivery of the physical wheat. Note that $5.88 price is at a zero (even with futures price) basis because you are delivering to the futures exchange.
If you deliver the wheat to Columbia International Grain in Harlem, Montana, (a grain elevator), you will be paid $4.90 per bushel, 20 under the September futures, a -20U basis (U = September).
The cost to transport your wheat 912 miles is much more than 20 cents per bushel, so you decide to deliver to Harlem, Montana.
So, you call Columbia International Grain in Harlem and make a cash grain sale of 10,000 bushels of Hard Red Spring Wheat at $4.90 per bushel for delivery during the next ten days.
What about your legal obligation to deliver 10,000 bushels of the same wheat to the Minneapolis Grain Exchange at $5.88?
The moment you hang up the phone after selling your wheat to Columbia International Grain elevator in Harlem, you call your commodity futures broker and place an order to buy 10,000 bushels of Hard Red Spring Wheat for September 2019 delivery “at the market” (the best available futures price at that moment). The order gets filled within seconds at $5.10½.
Now what happens?
The Minneapolis Grain Exchange sees that on January 14, 2019, you promised to sell (and deliver) 10,000 bushels of Hard Red Spring in September, 2019, for a price of $5.88.
The Minneapolis Grain Exchange also sees that in late August, 2019, you promised to buy (accept delivery) 10,000 bushels of Hard Red Spring Wheat for September 2019 delivery for a price of $5.10½.
Now read this carefully:
The Minneapolis Grain Exchange says (in essence):
“The January sale of 10,000 bushels of September wheat offsets the August purchase of 10,000 bushels of September 2019 wheat at $5.10½. There is no need to deliver 10,000 bushels of wheat and load out 10,000 bushels of the same class of wheat. We (the futures exchange) will just credit the farmer’s futures account with the price difference of $5.88 minus $5.10 ½, which is 77½ cents.
That 77 ½ cents is your money. You tell your futures broker to send that 77½ cents to you. You add that 77 ½ cents to the $4.90 a bushel Columbia International Grain in Harlem, Montana, will pay you for the wheat.
Thus, $4.90 plus 77½ = $5.67½, which is your net cash price for your wheat, 20½ under the September.
Between January and late August, you lost 78 cents in the cash wheat market, but:
Between January and late August, you made 77½ cents in the wheat futures market.
The loss in the cash market offsets the gain in the futures market.
The gain in one market offsets the loss in the other market. Remember, grain marketing involves two markets!
And that, Ladies and Gentlemen, is how a hedge works.
How Does a HTA Hedge Work?
A Hedge to Arrive (HTA) contract is a cash grain delivery contract. That means delivery is required. Why?
Because the grain elevator is doing the hedge of the price at the futures exchange to protect the price on behalf of the grain producer, the farmer.
So, the hedge (selling futures, going short) is done by the elevator instead of the farmer; the elevator sells the futures (going short) in their own futures account.
If a farmer takes the short (sold) position in his own futures account, delivery is not required because, on any business day, the farmer can offset his short (sold) position with a buy order of the same commodity in the same contract (aka “delivery”) month. The contract to deliver on the short (sold) contracts is offset by the contract buying the same amount of bushels in the same contract (aka delivery) month.
For the HTA, the elevator does the hedge for the farmer, who must deliver the grain to the elevator at some later date. The grain must arrive at the elevator, thus the name, hedge to arrive.
Example: If you are going to grow 10,000 bushels of Hard Red Spring Wheat and expect to deliver it in August or September, you would do a HTA in September at the Minneapolis Grain Exchange. How do you do you that?
You call the elevator’s grain merchandiser and simply state, “Place an order to sell 10,000 bushels of Hard Red Spring Wheat in the September 2019 contract at $5.88 or better (means ‘or higher’) for a HTA contract.”
The elevator executes the trade in their futures trading account and writes the HTA cash grain contract for you.
You are only doing business in one market, the cash grain market.
The elevator is doing business in two markets:
1) The elevator is buying your wheat for a later delivery period for cash (the cash market).
2) And, at the same moment the elevator agrees to buy your wheat for cash, it sells the wheat in the futures market to protect them from loss if the futures price declines between now and when you deliver the wheat.
They are hedging: buying in one market and selling in the second market at the same time to offset the risk of price change.
By late August, the September Hard Red Spring Wheat has declined to $5.10. Remember, you locked in the futures prices at $5.88 back in January.
You call the elevator to schedule delivery of your 10,000 bushels of wheat. The first thing you ask is, “What is the basis for nearby delivery?”
The merchandiser says, “Our basis is 20 under the September.”
You say, “OK, set the basis on my 10,000 bushel-HTA contract for delivery within the next ten days at 20 under the September.” The merchandiser does it.
You now have a “forward contract” for 10,000 bushels of Hard Red Spring Wheat for September delivery at $5.68 net cash price to you. The merchandiser modifies your HTA contract from a HTA to a forward contract.
The September futures price is locked in at $5.88, and the basis is locked in at 20 under the September futures. When the futures price and the basis are set, that is the definition of a forward contract.
You deliver the wheat and pick up your check.