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The problem with most risk management and hedging programs today is that there is a lack of a defined process. Too many producers and consumers are either trying to buy the absolute top/bottom of a market, getting nervous and buying/selling on impulses, or simply buying to a budget.
From a risk management perspective, all of these strategies will almost certainly result in failure over time. The primary reasons for this are below:
- If you could time the market, you would be sitting on a beach somewhere, not working. There is not a sole on this earth that can consistently time the market.
- Markets are impulsive, if you get nervous and buy/sell or those nerves you do not have a plan that you are following. It is widely known and accepted that markets overshoot highs/lows and chances are that is when you will be buying/selling.
- If you are buying to a budget, you are not considering supply and demand. Buying to a budget works in some instances, but not in others. What if the market never gets to your budget? what if your budget is too high/low? Additionally, buying to a budget can leave you uncompetitive relative to others in your industry, but that’s an entirely different issue.
So, what do you do?
Through the years I have developed a repeatable risk management process that takes the vast majority of the guesswork out of hedging. The steps to do this are below:
1. Understand the true risks by understanding the true exposure.
If you don’t have a firm understanding of your true exposure, you may be adding risk to your business instead of removing it. Understanding your true exposure means not only understanding what risks exist in the business, but also the timing of those risks and when they need to be hedged.
2. Let the relative value of the market determine your hedge tool and hedge duration.
Using the same hedge tool over and over again in different market conditions is not the optimal solution. To be successful, you need to let the market guide which tool you use and even how far out your average coverage should be. To do this, I have always quantitatively looked at the market to tell me whether it is relatively over, or undervalued, for a specific time period and use that as a guide.
3. Take seasonal market considerations into account for duration.
Successful hedging requires taking seasonal market tendencies into account when looking at duration. Does it make sense for an end user of corn to cover their needs for the upcoming year between May and July? Probably not. If they were willing to wait until August to October (only a short difference) the seasonals would be working with you instead of against you.
4. Use systematic indicator to time market entry and exit.
The backbone of my risk management program is my systematic indicator. This indicator looks for extreme overbought and oversold levels in the market and produces buy/sell signals. The idea is to take all of the guesswork out of market timing and replace it with something that’s repeatable and testable. I have spent years developing, tweaking, and refining this model so that it works across markets. Is it a silver bullet? No, no such thing exists. What is does, is have a track record of allowing consumers to buy below the average market price and allow producers to sell above the average price in most years. Using this model in combination with relative value duration and tool analysis, and seasonal duration considerations produces a consistent, repeatable hedge process.
5. Conduct ongoing position maintenance via pre- and post-analysis.
Once hedges are established, they need to be maintained. Conducting pre and post analysis let me optimize hedges while they are still working for the business and also provide the opportunity for lookbacks to see what could be improved going forward.
Does it work?
In an effort to be transparent, I run a model producer/consumer hedge model that I update weekly to show how things are preforming. I detail all of the changes in my Free Weekly Market Commentary to let people get a better sense for my process as it unfolds. I also update a weekly hedge summary here:
Historic Systematic Model Results:
Corn:
Soybeans:
Wheat:
Soybean Oil:
Soybean Meal:
Lean Hogs:
Live Cattle:
Diesel Fuel: