Beware of the 'Texas Hedge'

Beware of the 'Texas Hedge'
Combine and truck harvesting wheat.

Some of you may be wondering, in this rising wheat market, “why not place a long hedge or purchase a call option?”, while also holding unpriced grain either in the field or in the grain bin.

These thoughts are often motivated by our beliefs of where commodity markets are headed. Currently, this could be due to market uncertainty stemming from COVID-19. The strategy of placing a long hedge or purchasing a call option while owning unpriced grain is commonly known as a “Texas Hedge”. The Texas Hedge exposes farmers to more price risk, price risk that may not be worth the financial pain if things don’t work out.

The premise of buy low, sell high applies to trading futures and options. Taking a long position in the futures market assumes that you anticipate the price to increase. To “go long” in the futures market, you must buy contracts now, and hoping to sell them later for a higher price. For example, you buy a Kansas City Winter Wheat contract at $5.10 per bushel today and before the contract expires, you sell your contract at $5.50 per bushel gaining $0.40 per bushel (Example 1).

Example 1: Going Long
Place Buy (-) $5.10
Lift Sell (+) $5.50
Gain/Loss $0.40

As a grain producer, you naturally hold a long position in the cash market because you are producing grain to sell it at a later date. Thus, “going long” in either the futures market or options market while holding unpriced grain in the bin or in the field automatically makes you a speculator. Hedging by definition is taking a position in the futures market that is opposite of your cash position. With the Texas Hedge you are not protecting yourself from declining prices. You are betting that the market will go higher.

A Texas Hedge is the perfect example of speculation. As a farmer, if you take a long position in the futures market like the one illustrated above, and the market declines you are exposed to more risk. As you lose money in the futures market you are also losing value in your growing crop. A Texas Hedge doubles down on your assumption that prices will increase. Example 2 illustrates how a Texas Hedge can be harmful to a farm’s marketing strategy.

Example 2: A "Texas Hedge"
Place Buy (-) $5.10
Lift Sell (+) $4.70
Gain/Loss -$0.40
Cash Price $4.15
Actual Sale Price $3.75

To properly illustrate this scenario, we must add cash prices to the story.

Earlier this year the futures price was $5.10 per bushel and the basis at your local elevator was $0.55 per bushel under, making the cash forward contract price $4.55 per bushel [$5.10 +(– $0.55)]. You anticipate that the market will go up, so you take a long position in the market, i.e. a Texas Hedge, buying futures contracts at $5.10 per bushel.

Since you bought futures contracts, the market has declined. You decide to lift your position. You sell your contracts at $4.70 per bushel, losing $0.40 per bushel in the futures market ($4.70-$5.10). That same day, you cash forward contract to the elevator. Basis at your local elevator remained at $0.55 per bushel under, making the cash price you received $4.15 per bushel [$4.70+(-0.55)]. This makes the actual sale price of your wheat $3.75 per bushel ($4.15-$0.40) less any trading fees i.e. rather than just losing $0.40 per bushel due to the futures price decline from your unpriced grain, you lose $0.80 per bushel.

This example assumes that the basis value remains steady. However, in reality you are also exposed to basis risk until the cash price is determined.

You may be thinking, “a short hedge can go wrong too!” Let’s look at scenario similar to Example 2 where the farmer loses $0.40 per bushel in the futures market with a short hedge.

Example 3: A Short Hedge
Place Sell (+) $5.10
Lift Buy (-) $5.50
Hedge -$0.40
Cash Sale $4.95
Actual Sale Price $4.55

To protect yourself from declining prices, you need to place a true hedge or short hedge.

Earlier this year the futures price was $5.10 and the basis at your local elevator was $0.55 per bushel under, making the cash forward contract price $4.55 per bushel [$5.10 +(– $0.55)]. You anticipate that the market will decline, so you take a short position in the market, also known as a “True Hedge”, selling futures contracts at $5.10 per bushel.

Since you sold futures contracts, the market has increased. You decide to lift your position. You buy your contracts back at $5.50 per bushel, losing $0.40 per bushel in the futures market ($5.10-$5.50). That same day you decide to cash forward contract to the elevator. Basis at your local elevator remained at $0.55 per bushel under, making the cash price you received $4.95 per bushel [$5.50+(-0.55)]. This makes the actual sale price of your wheat $4.55 per bushel ($4.95-$0.40) less any trading fees. In this scenario, as you lost money in the futures market you gained value in your growing crop. The total loss here is only $0.40 per bushel less any fees where the sale price is exactly what you expected: $4.55 per bushel. Furthermore, the farm average price is likely to increase with additional sales of unpriced grain through the market rally.

If you were correct in your assumption that the market would rise, a Texas Hedge would provide a large return, however, is the risk worth the reward? Commodity markets operate in complex environment with participants engaging in different strategies with different forces impacting them. As a result, it is difficult to predict price behavior consistently. We also over emphasize opinions that support our beliefs. Engaging in a Texas Hedge during volatile times can lead even worse financial outcomes Beware of the “Texas Hedge”. This strategy may work for speculators but for farmers looking to protect their price, this strategy can be detrimental, especially when farm failure due to poor financial performance is on the line.