Your elevator bids 40 cents a bushel under the December corn futures price on your broker’s screen, and on 50,000 bushels that gap is $20,000. The price you keep after selling futures is the futures price you locked, less that gap, which the trade calls the basis. If the basis comes in 15 cents worse than you expected, the same 50,000 bushels bring $7,500 less. Before you sell any contract, write the price you expect to keep next to your cost of production, and size the hedge from it.
The figures here are an example for a farm in Iowa that expects 100,000 bushels of corn, not market quotes. The farm sells December corn futures on CME, the Chicago exchange. Selling futures to fix a price before harvest is what the trade calls a short hedge. In the hedging scenario calculator you enter the same two numbers and get back the price you keep, not the one on the screen.
What you end up with is a hedge sheet, one page on paper or in a spreadsheet. On it you write the price you keep, the worst basis your costs can take, the bushels you hedge and why, and the cash set aside for the broker’s margin deposit. Fill it in before the broker calls, because during the call the futures quote is usually the only number on the screen.
What price do you keep when you sell futures?
You keep the futures price minus the basis gap, because the contract is priced at a delivery point that is not yours. Dhuyvetter, in a basis guide from Kansas State University extension, writes the arithmetic in one line: “Cash Price - Futures Price = Basis”, taken at the same moment. He gives the sign too: “A negative basis implies the futures price is greater than the cash price”. Freight, handling, storage, quality and local supply open that gap, so a farm far from the delivery point usually sees a negative basis.
You sell futures now and buy them back when you sell the grain. If prices fall, the grain loses value and the futures position gains about the same. CME Group puts the result plainly: “Once you establish a hedge, the futures price level is locked in. The only variable is basis.”
Check the arithmetic from both sides. If the local price at delivery is $6.00 and the basis came in at 40 cents under, futures stand at $6.40. Buying them back costs $1.60 more than you sold them for, and $6.00 minus $1.60 is $4.40. If the local price is $3.60, futures stand at $4.00, the position gains $0.80, and $3.60 plus $0.80 is $4.40 again.
What if the basis ends up somewhere else?
Then you keep a different price, because the basis is the one number the hedge leaves open. CME Group states the trade in one sentence: “By hedging with futures, buyers and sellers are eliminating futures price level risk and assuming basis level risk”. In the example, a basis of 55 cents under instead of 40 gives $4.25 a bushel, which is $7,500 less on 50,000 bushels. Only the hedged bushels carry that risk, because the unhedged ones sell at the local price of the day, which already contains whatever basis turned up.
The trade usually pays because the basis moves less than the price. Kansas State says basis levels generally can be predicted with more accuracy than either futures or cash price levels. Less movement is not zero movement. The basis reflects local supply and demand, and in the guide’s wheat example “basis became more negative as the 1990 wheat harvest got underway”.
Your expected basis comes from your own record. Take the average basis for the same week of the year, at the same delivery point and against the same contract month, over three to five years. Kansas State calls this the most common method, “a historical average (3-5 years)”, and its example is a five-year average of weekly basis for soybeans in Topeka, Kansas. The week matters because the basis at one place changes through the year. An average of the last few weeks gives you the basis of now, not the basis of your delivery week.
With only a year or two of your own prices, average the most recent weeks and treat the result as a starting point. Those years come from a price record with a source, a weekly log of your buyer’s bid, the futures quote and the gap between them. Write the expected basis with the date, the place and the contract month it came from. A basis borrowed from another delivery point or another month is a different number under the same name. A local crop bigger than in the years of the average calls for writing the basis further under, with the size of the adjustment and the reason beside it.
Your floor sets how far the basis can go. The break-even basis is the floor minus the locked futures price: $4.10 minus $4.80 is minus $0.70, or 70 cents under. With an expected basis of 40 cents under, you have 30 cents a bushel of room. If the basis comes in worse than 70 cents under, the hedged bushels bring less than they cost. That room applies to the hedged bushels only, and the unhedged ones keep following the market.
How many bushels should you put on futures?
Fewer than all of them, and a table of prices at delivery shows why. Each row is one local price at delivery. Next to it is what the whole crop averages with no hedge, and with 50,000 of the 100,000 expected bushels hedged at $4.80 and a basis of 40 cents under.
| Local price at delivery | No hedge | With 50,000 of 100,000 hedged |
|---|---|---|
| $3.60 | $3.60 | $4.00 |
| $4.20 | $4.20 | $4.30 |
| $4.80 | $4.80 | $4.60 |
| $5.40 | $5.40 | $4.90 |
| $6.00 | $6.00 | $5.20 |
With no hedge, what you receive spans $2.40, from $3.60 to $6.00. With half hedged it spans $1.20, from $4.00 to $5.20. Only the unhedged half still follows the market, so hedging half halves the range and hedging everything leaves only the basis moving. At $3.60 the average of $4.00 is still 10 cents under the floor, because the unhedged half sold at $3.60.
The cost of that protection is known before you sign. At the best price the hedge cost $0.80 a bushel, $6.00 against $5.20. At the worst price it earned $0.40 a bushel, $4.00 against $3.60. You buy a narrower range of income, and the gain you give up in a rally is what you pay for it. The range matters most to a farmer with a fixed loan payment, cash that will not last a bad quarter, or inputs already bought at a set price. With cash to spare and freedom to choose the month of sale, the same protection gives up gains for little use.
The number of bushels comes from the smallest of three limits. The first is a yes-or-no floor test: $4.40 clears the $4.10 floor, so there is a share to hedge. If it did not, the share would be zero, because a hedge that locks a price below cost removes the uncertainty about a loss. The second is the production you are sure of, not the one you expect. In the example the farm is sure of 85,000 bushels and has sold 20,000 under other contracts, which leaves 65,000. Count those 20,000 once, with the volume already priced.
The third is the cash you can keep sending to the margin account while the market rises, covered in the next section. Here the farm can carry a $1.00 rise on 50,000 bushels. The smallest of the three is 50,000 bushels. CME Group notes that “each futures contract equals 5,000 bushels” of corn, so that is 10 contracts. Write the number and the reason it is that one next to it on the hedge sheet, because by next year the reason is what you forget.
Hedging more than you grow turns protection into a bet against the market. Contracts come in fixed sizes, so rounding up on a small crop can pass your expected production. A short harvest does the same: a position sized for the yield you expected covers more than the yield you got. Compare the hedged bushels with the production estimate every time the estimate changes.
In the example, 150,000 bushels hedged against 100,000 grown average $4.80 a bushel if the market ends at $3.60 and $3.60 if it ends at $6.00. The extra 50,000 bushels gain when the market falls and lose when it rises, on grain you do not have. The calculator shows a warning when you enter more than the expected production.
Sometimes the right number is zero even when the price clears the floor. That happens if the basis was never measured at your delivery point, if this year’s production is too uncertain for any ceiling, or if no cash is set aside for a long rally. Measuring the basis, revising the estimate and setting cash aside fix all three. Farmers can also misjudge how far prices move. Cruz Júnior and colleagues surveyed 90 corn growers in Brazil in 2008 and found that they held a perception of risk below the risk of the market, a finding from one country and one crop.
What cash does the hedge need before delivery?
A short hedge pays nothing for months and asks for cash first, and the request comes when prices are rising. CME Group describes the mechanism. When the futures price moves against an open position, funds will be withdrawn from the customer’s margin account to cover the loss. Margin is the deposit the broker holds against your position, and topping it up is what the guide calls receiving a margin call.
A short hedge loses on the futures side when prices rise. In the example, a $1.00 rise in the December futures price takes $50,000 out of the margin account on the 10 contracts. The higher price for your grain reaches you only at delivery, months later. You can be protected on price and still run short of cash. The calculator gives you the price at delivery, not the cash you need on the way.
Ask the broker for the margin per contract before you sign, and set aside cash for a rise as large as the market has made before. A position you cannot carry to delivery gets closed at the worst moment, with the futures loss already paid and the gain still in the field.
What goes on the hedge sheet first, and how long does it take?
An hour with your price record, the futures quote and your cost of production, before the broker calls.
The blank line at the bottom is the one that pays off. Fill it in at delivery and you see how far the real basis landed from the one you expected. After a few seasons your expected basis comes from your own record instead of a borrowed average. Before the sheet itself comes the break-even price, your cost per bushel.
That line, the gap between the exchange quote and your own buyer’s bid on delivery day, is a piece of marketing no one else can keep for you. In farm management, a record like this is what the other decisions on the farm draw on.