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Manage market risk, don't speculate

When a commodity broker said, ‘I think,’ you can be sure you as a grower are about to lose money,” said Mark Gold, managing director of E-Hedger in Chicago.

Speaking at the recent 17th annual joint meeting of the North Carolina Corn, Soybean and Grain Producers Association in New Bern, N.C., Gold said trying to outsmart pit traders who make their living buying and selling commodities is always going to be a losing proposition for farmers.

“I would love to stand here and tell corn and soybean growers that corn prices will be $4 a bushel and soybeans $8 a bushel. I hope prices are that good, but I don't know that, and more importantly, neither does anyone else,” he said.

Gold said risk is known for all commodities traded and managing the risk is a much smarter approach than trying to guess what prices will do. The risk for soybeans, he said, is $4 per bushel, for corn it is $1.40 and for wheat $2.40.

Gold explained that all commodities are assigned a risk factor. For example, oil risk is $90 to $100, and all buying and selling should be based on these risk factors.

The greatest grain risk right now, according to Gold, is soybeans. He noted that the 505 million bushel carryout for beans is the highest ever recorded. That in itself doesn't mean soybean prices will fall to $4 a bushel, but it is a good indicator, he said.

Soybean exports are 13 percent behind USDA projections and the window for exporting beans is closing rapidly as the Brazilian soybean crop begins to hit the market, he warned. In 2006, U.S. farmers are expected to plant 2 million to 3 million more acres of soybeans, most coming from growers switching from corn — that adds to the risk, he explained.

Right now corn stocks are high and wheat stocks are low. “It looks like a good year to trade wheat, but indicators can change rapidly. From my perspective, it is a good year to manage the risk on wheat, compared to soybeans,” Gold said.

The best way to manage risk in a crop is to not speculate. Over 90 percent of growers who speculate lose money. Brokers make a living by generating commissions on trade, so many want their customers to speculate. Forecasts and analyses only turn into speculation, because no one truly knows where the market is going.

“In my 30 years trading commodities, I have come to believe and understand that world stocks and world carryouts are the two things that move markets in the long-run,” Gold said. Based on these two criteria, worldwide, soybean growers need to be very careful about selling their crop, he said.

“I'm telling you there is no one out there who knows where the market is going and those who have the best insights are making money — not advising other people,” Gold said. The people who are making money trading commodities don't write newsletters and don't share their secrets with many people, he added. “To be successful in the commodity market, you have to take the emotions out of it and manage the known factors, which are risks,” he said.

“I believe the best way to manage risk is with options,” Gold said. “You should look at put options as an insurance policy to protect you, should prices go below the risk value of the crop,” he added. “Like with any insurance policy, you prefer to not collect any money from the insurance.

“We know that in any seven out of 10 years in the grain market, the price tends to go down. So, about 70 percent of the time, put options will pay off,” he said. “For example, if you have 50,000 bushels of corn and it is going to cost you 10 cents a bushel to buy put options, it will cost you $5,000, plus my fee of $37.50 per contract, for a grand total of $5,375 to insure your corn,” he explained.

“As soon as you understand that you want to lose every penny of that $5,375, you will become a better marketer,” Gold stresses. “You also have to understand that I'm never going to ask you spend that $5,375 unless I believe you have the opportunity to make at least $15,000 on the trade,” he said.

The other end of the spectrum for managing risk is the call option, Gold noted. “Once you sell your grain, look at the call option as your lottery ticket, should that grain go up dramatically in price,” Gold said.

“The best example of call options coming into play was in 2004, when we had $8 new crop beans in March. We advised all our clients to sell 50 percent of their crop for $8. To help them pull the trigger on $8 beans in March, we advised them to buy the call option for 25 cents a bushel. The worst they could do was make $7.75 bushel on their beans. If the prices went to $10 to $12 a bushel, they would make a lot of money.” In 2004, he said, farmers made money on call options.

The disadvantages of using options to protect risk is that 85 percent of them expire worthless, they can be a strain on cash flow and there is a perception that no one ever makes money buying options.

When to use options to protect risk is the tricky part, Gold said. “I use three criteria to determine when to use options.

“First, the risk/reward ratio must be at least 3:1, don't buy puts close to the loan value of the crop, and don't spend a dime to protect less than 30 cents,” Gold explains.

Second, look at world carryouts. Typically, when carryouts are high and on the rise, prices come down, making it good risk protection to buy put options.

Third, look at where in the market grain is trading. For corn, the lower third is $2.40 and lower, the middle third is $2.40 to $2.80, and the upper third is $2.90 and up. If grain is selling in the bottom third, look at buying a call option. If it is in the top third, buy put options, because historically seven out of 10 years prices go down during the trading season, Gold explains.

Gold admits there is a risk in trading futures and options. However, he contends there is more risk to the farmer who is storing soybeans right now. “If you don't protect your risks by using options contracts, I believe you are exposing yourself to too much risk,” Gold said.

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