Scheve: The Dreaded Margin Call And Why I Do Not Fear It
Dec 31, 2018
Market Commentary for 12/28/18
There are many factors that affect the futures market. It's easy to rationalize why the market could be headed for a rally or a decline at any given time. Last week I discussed the reasons to be bearish or bullish corn. This week I discuss beans.
Reasons To Be Bearish:
- The most massive carryout in bean history – currently at 950 million bushels
- Good weather throughout much of Brazil for most of the growing season
- The Brazil harvest is beginning this week and will be in full swing before the end of January
- Lack of adequate storage requires South America to move their beans shortly after harvest
- China has not bought many US beans this year
- The Asian Swine Flu in China could be much worse than stated and demand for soybeans could be greatly reduced
- China claims to have found substitutes for soy in their pork diets
- China has adequate stocks of soybeans and could wait a year to replenish their supply without buying US production
- Last year Argentina had one of the worst droughts in 40 years. This year weather has been better and larger crops are expected.
- China bought beans twice in the last 2 weeks and the market went down both times
Reasons To Be Bullish:
- Beans continue to trade higher than many have predicted
- Many beans here in the US found storage in every nook, cranny and silage bag available
- It's possible there could be a political solution to the trade tariff issue and it could include China buying much more if not all of their beans from the US for the next year or two to help with the trade imbalance
- Parts of Brazil have seen some dry weather and there is some debate as to how much production will have been effected
- Argentina has many more weeks than Brazil until harvest and weather could still impact production there
- The rest of the world could still buy US beans even if China doesn't
The Dreaded Margin Call And Why I Don’t Fear It
Last week I discussed the benefits of selling straddles or calls on a portion of my corn production. When setting up trades I always know all possible outcome if the market goes up, down or sideways. In the example provided last week, if the market rallies, I might be forced to sell corn futures for $3.99 against the March for my ’18 crop, which I'm comfortable doing with what I know today. I also have orders working to sell more of my 2019 crop, so that if the market rallies my sales targets will hit.
However, if the market rallies those positions will likely put me into a situation where I'll have to make margin call on some, or hopefully all, of my sold production.
Misconceptions Concerning Margin Call
Recently a market analyst said he would never short a call because if the market rallies significantly the seller would have unlimited margin call. He went on to say there was no way to protect yourself against this type of situation. He tried to scare farmers into thinking they would go broke making these types of trades.
He then talked about how farmers will lose money chasing a position that goes against them and how they will lose money in both directions. While that could happen, it would only be the case if the farmer was chasing a position trade, which sounds highly speculative to me. I would never put myself into a position where I would have to chase the market on a rally, because I’m completely fine limiting my upside potential on some of my production in exchange for guaranteed premium now.
Do You Ever Trade Out Of Your Positions If The Market Moves Against You?
No I don't. As I have said many times before, when I place a trade I'm comfortable with all outcomes. If I’m not comfortable with an outcome then I don’t place the trade to begin with. I hope I'm forced to sell some of my grain on any calls and straddles I sale because that means the market rallied.
Aren't You Afraid Of Margin Call If The Market Rallies Then?
Margin call makes a lot of farmers wince and keeps many from selling options or even making forward sales using futures.
Sadly, these farmers (and apparently that analyst), don't realize they are removing an important marketing tool out of their grain marketing tool box. Eliminating margin call is like telling a baseball player to not swing at anything IN the strike zone. A player may do alright swinging at questionable pitches, but they increase their odds on missing and striking out. Just as it sounds silly to tell a baseball player to not swing at strikes, it sounds silly to me to tell farmers not to hedge their grain using futures or selling calls because they don't want to pay margin call.
Why Should Farmers Not Fear Margin Call?
As a true hedger, I don’t like calling it a "margin call," because that term is most often associated with speculators. A speculator making a margin call is in a bad financial situation because a trade has gone against them. I’m not a speculator because I have the underlying commodity to cover any sale I’m making. I’m a hedger and that is a major difference when looking at grain marketing and risk management decisions. A true hedger making a “margin call” is more accurately just making a finance decision. It’s not a bad thing. Let me explain.
Margin Calls For Hedgers Are Typically A Net Neutral (Neither A Gain Or Loss)
When using the futures market to hedge or sell grain, it doesn’t really matter if I have to make a margin call. Following is an example:
Let's say December futures are $4/bu in June and I sell some December corn futures because that seems like a great value to sell some corn. Then in August corn rallies due to a huge weather scare and December corn increases to $6/bu. Margin call means I have to have the difference between what I have my grain sold for in futures ($4), and the current CBOT futures price ($6). So, in this example I would need to make a $2/bu margin call to my futures trading account.
This part frightens farmers, because that can be a lot of money. But, there is no reason to be worried, because I’m not losing that money.
Let’s assume that I will harvest my grain in October and take it to the elevator. For simplicity, let's also assume the price in October is still the same as it was in August - $6. (the actual price in October would not really matter because the finaloutcome will be the same at any price level). So, I sell my grain for $6/bu cash to the elevator and they hand me a check for $6/bu. At the same time I sell to the elevator, I buy futures back in my hedge account for $6/bu. This buy back keeps me net neutral on my hedged position. I had already sold in June when I picked a value I wanted for my grain.
The important part of this example was when I sold the corn for a cash contract, I immediately bought the same amount of bushels back in my hedge account, otherwise I would have become a speculator. I always have to keep my position net neutral on bushels when I sell my crops for cash and have a futures position. Remember, I'm not a speculator, but instead just a hedger. In this case I got out of my hedges as I sold the grain for cash and delivered the grain to the end user. Even if I think futures can move up or down I have to take the position off when I make the cash sale. Not doing so crosses the line from being a hedger to a speculator instantly.
Now, when I combine my hedge account and the check for the physical grain from the elevator, I lose $2/bu in my futures account, but I still sold the corn for $6/bu cash. This is where I net out $4/bu between the two accounts, which is where I originally made my sale. At the time I sold in June I thought I was making a good sale. This is also the point where I have got back all of my margin call money. It came in the check for the physical grain which was sold for way more than my original planned sale. That premium offsets the loss in the hedge account and fully pays down the margin call amount in the account.
I Don’t Have Cash Just Lying Around To Make Margin Call Payments. This Sounds Bad.
Most farmers don’t have a lot of cash laying around. Farmers hedging grain need to work with their bankers. When I work with farmers, I work with their bankers first to make sure the banker understands the plan and to set up a path for margin calls as a part of a hedging position. This is a low risk loan for bankers, so they are usually extremely supportive. Many bankers will set up what is called a hedging line that is related, but separate from the operating note.
In the above example I sold futures in June and delivered at harvest (4 months later). If the rally didn’t start until August, it would mean a $2/bu loan for 3 months (August to October). With a typical interest rate of 5.5% on a hedging or operating loan, this means only 2.75 cents/bu interest for the margin call for those 3 months (math = $2 x 5.5% / 12 months for a monthly rate x 3 months).
Why Would I Even Do This Then? I Could Have Just Sold Grain To My Elevator And Not Worried About Margin Call.
If corn rallies due to a major drought, you can’t take advantage of increasing basis levels and other premium opportunities unless you use futures contracts or if one uses Hedge To Arrive contracts (HTA’s). For instance, in 2012 (a drought year), I received $.80/bu more for my corn in the form of basis with what I sold using futures than farmers who sold corn for a flat price to an end user the same day as me and took the cash price quoted on presells before harvest.
Why Not Use An HTA And Let Someone Else Make My Margin Call?
There are several reasons:
- Benefit #1 - Costs Are About The Same - I prefer to carry my own hedge because the cost of an HTA is approximately the same price as I will have in my futures brokerage and the interest on a huge margin call. HTA's costs vary with end users, but they range from 0-8 cents with most in the 3-5 cent range. So in the above example I might have 2.75 cents of interest and 1 cent in commissions to my broker to make the trade. Basically it’s the same cost as what my elevator charges me to handle an HTA and that is assuming a $2/bu margin call. If I have only a 50 cent margin call all year then I’m way ahead to handle my own hedge as to paying someone else more to carry my hedge. ($.50 x 5.5% / 12 months for a monthly rate x 3 months = about ¾ of a cent of total interest)
- Benefit #2 - I'm Not Locked Into Any One End User. It allows me to go with the end user who is paying the most at, or any time after, harvest. It’s not uncommon to see end users have 10-20 cent pushes in their bid in years with short production and large margin calls after harvest is complete to grain not already locked in with an HTA or stored at the end users facility. I want to be able to take advantage of this premium in the market. I can’t guarantee where the best bid will be 3-6 months in advance so locking my grain up with an end user now is not something I want to do. This year with the delayed harvest I saw farmers who were able to ship corn in late November directly from the field at much better basis prices than what farmers were getting in early October. The market is always changing and having complete control over my own bushels allows me to take advantage of every available opportunity.
- Benefit #3 - Easier To Get Out Of Sales If I’m Short On Production. If I am unable to produce corn (e.g. due to weather), it’s easier to get out of sales by moving them forward with futures to the next year I will produce grain. Most of the time I can actually capture a profit doing this. If I have to ask an end user to be let out of contracts, be it cash trades or HTA’s, there will probably be a penalty price. Even if the end user offers to move the sales to the following year for free that is a huge loss to me because usually there is extremely good carry in the corn market from one year to the next. This year there was over a 40 cent premium to move sales from ’18 to ’19. In the past 30 years there have been only 3 years where there wasn’t eventually a carry in the corn market (95/96, 11/12, and 12/13). Even in those years end users weren’t likely to move the sales forward at the same price. They probably charged the difference of the spread between crop years.
- Benefit #4 - More Flexibility - For example, in 2012 when the market rallied above $7, some elevators refused to place more HTAs and in a few cases made farmers set basis on HTAs already traded when basis was near their lowest/widest value. This happened because these elevators didn't secure large enough lines of credit from their banks and were forced to liquidate their position. I don’t want to have my profits reduced because of somebody else’s failure to plan ahead. I want to be in control of my money, my bushels, and my profits.
Myth – Making A Margin Call Is Bad
Many farmers may be shocked by this, but making a margin call can be a GOOD thing. Here’s why….
Typically, I don’t price all of my corn at one time, and I doubt most farmers do either. I usually hold some back for potential market rallies. As described above, I have to pay margin call on all of my priced or sold grain with every rally. But, this means the corn I haven’t priced or sold yet is now worth more. ALL future unsold grain is now worth more. Since I plan to farm well into the future, I have more corn to sell, maybe not this year, but next year I will.
***Margin call means corn you haven’t priced or sold is worth more. Embrace it.***
I Understand That The Math Makes Sense, But I’m Still Too Scared Of The Margin Call.
Many of the farmers I have worked with expressed reservations and fear the first year as they cut several $5,000-$10,000 margin call checks during the months of June and July (despite knowing they will eventually get it back). It can be a lot of money. However, once they saw that not only did they get the money back later, but they also had more opportunity at improved basis levels than their neighbor, who didn’t use futures. Typically after the first year those farmers wonder why they didn’t start using futures sooner and embrace margin call.
Don’t let your fear of margin calls keep you from using the biggest marketing tool there is to hedge your grain and take advantage of market opportunities. Savvy farmers understand it and use the tools that are available to increase profits and minimize risk.
Want to read more by Jon Scheve? Check out these recent articles:
How I Collected 29 Cents Of Premium On 10% Of My 2018 Corn Production
The Pros And Cons Of Selling Straddles
Capturing Carry And Paying For Storage
What I'm Doing With Some Of My Remaining Unsold 2018 Corn
How I Collected 65 Cents On 10% Of My Corn Production With 4 Options Trades
Why I Think Buying Calls Is Gambling And Why I Avoid It
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