Introduction to Hedging Agricultural Commodities with Options

Abstract

Producers of agricultural commodities regularly face price and production risk. Furthermore, increased global free trade and changes in domestic agricultural policy have increased these risks. As the variability of price and production increases the variability of revenue, producers are realizing the importance of risk management as a component of their management strategies. One means of reducing these risks is through the use of the commodity futures exchange markets. Like the use of car insurance to hedge the potential costs of an accident, agricultural producers can use the commodity options markets to hedge the potential costs of commodity price volatility. However, as with car insurance, where the payments from a small insurance claim might not exceed the cost of the premiums paid, the gains from hedging agricultural commodities might not cover the costs of hedging. The primary objective of hedging is not to make money. The primary objective of hedging is to minimize risks and this includes using hedging to minimize losses. This guide provides an overview of hedging to aid producers in evaluating hedging opportunities.