The Fine Line Between Hedging and Speculating

By Betsy Jensen
Ag Commodity Instructor, Northland Community and Technical College betsy.jensen@northlandcollege.edu

There’s a fine line between hedging and speculating. As I sit in the marketing groups with farmers, we often question the recommendations of professional advisors.  Are their recommendations minimizing risk, in other words, a hedge? Or are they speculating and adding to the already enormous risks we take in farming?  We often laugh and turn the recommendations into a Jeff Foxworthy joke by remarking “You may be a speculator if...”

But speculating is nothing to laugh at.  It’s not a joke to lose your job and the respect of your peers by having your name and commodity losses published in the paper, as what happened earlier this year in North Dakota. It’s not a joke to be forced to sell land to pay for your margin calls.  It’s never a joke to lose money by speculating on commodity prices, especially when you, or perhaps your parents and grandparents, worked hard to earn it.

As farmers we are forced to use the commodity markets every day. We watch prices go up and down, and understand the impact it has on our balance sheet.  If you asked the Average Joe in a metropolitan area how to trade the commodity markets, you’d get a blank look. Matter of fact, you’ll see some of those blank looks in farm country too.

Still, many farmers are familiar with the risks of trading commodities, and after a while, the familiarity with the markets can be mistaken for knowledge. Since we understand how prices go up and down, then we must have some inside information. We know how the crop looks in our back yard, and our knowledge is superior to others in the commodity markets. We know more than everyone else, and can make money with that knowledge – right? 

Well, those connections between familiarity and knowledge are wrong and can be dangerous. One does not lead to another, and trying to tie them together can be very costly.   The commodity markets were created in the 1800’s (the Chicago Board of Trade began in 1848, Minneapolis Grain Exchange in 1881, and Kansas City Board of Trade in 1876) in order for buyers and sellers to minimize risk by allowing them to forward contract. The speculators came later, and are a completely different set of traders with entirely different jobs.  Now some farmers are trying to work both jobs.

But as farmers, the priority is to produce a commodity, and sell it. If you want to begin speculating, make sure you use a separate trading account, and consider trading a commodity you know nothing about, such as cotton or sugar. I’m serious: you have no better knowledge about whether or not wheat is going up or down than you do about cotton. You may think you know what direction wheat is headed, but how is your knowledge superior to that of someone on the trading floor? They read the same reports you do, but they may actually have the advantage. We become biased by looking out our back window, and forgetting about the rest of the world. When they look out their back window, they might only see Lake Michigan, but rely on reports from all over the world to make their trading decisions.

If you want to play the futures markets, I’m a big advocate of using commodity trading accounts.  I believe that every farmer should have the ability to call a broker at a moment’s notice and tell them “Sell 10,000 bushels of December Minneapolis wheat.”  I like trading accounts because you sell the wheat but decide later which elevator to deliver. Maybe you’ll harvest some low protein wheat, and reduced discounts at one elevator may mean an extra $.20 per bushel. Selling commodities with a trading account does mean the risk of margin calls, but with interest rates so low, the cost of the money is minimal compared to what you could gain.

And, if you do choose to open a trading account, make sure you have some firm rules for the account. Can you say “No thanks” to a broker who is recommending buying call options on 150% of your wheat? Will you be able to make margin calls on your positions? It’s difficult to make margin calls, and I speak from experience.  My neighbors may have sold wheat at the same price as me, but the elevator is making their margin calls.

Before you open that trading account, make sure you have the discipline needed to be a hedger, and not a speculator. You can do a good job marketing your grain just by using your local elevator, but having a brokerage account gives you a few more marketing alternatives, if used correctly. 

Jensen farms with her husband Brian near Stephen, Minn.  Her market education activities including this column are supported in part by the Minnesota wheat checkoff, directed by the Minnesota Wheat Research and Promotion Council. If you have a question or topic related to marketing that you’d like to see addressed in this feature, call 1-800-242-6118, or email Jensen: betsy.jensen@northlandcollege.edu

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What is the difference between hedging and speculating?

A hedger is either a producer or user of an actual commodity. A hedger might take a position in a futures market in anticipation of future sale of cash commodities to protect against declining prices or in anticipation of future purchase of cash commodities to protect against rising prices.

A speculator participates in the market as an investment, with the intention of profiting from the sale or purchase of futures contracts for commodities he neither producers nor uses.