Jul 28, 2020

Start with Balance & Focus to Be a Basis Trader

Becoming a master basis trader takes years of honing skills, but key concepts can lay a solid foundation

I own a set of golf clubs. Does that make me a golfer? Nope. As a matter of fact, despite having owned golf clubs for 20 years, I would rate my golf game as only slightly above embarrassing.

There is little doubt that one of the things that hold back my progress toward the PGA is my lack of practice. I only golf two to three times each year, and though I’m not sure there’s a lot of hope for me either way, I’m not going to refine my game without some more commitment toward honing my skills.

Similarly, does having a futures account for your elevator make you a basis trader? Surely not. Being a good basis trader takes commitment. It’s not easy to be successful with halfhearted effort. A good basis trader will spend an entire career refining his/her basis trading knowledge and skills. There are a some key concepts, however, that serve as the foundation of all the other skills.

Keep a balanced position

Just having positions in a futures account does not mean you are hedged. I’m not trying to write a riddle, but the concept of being hedged seems to get thrown about haphazardly at times. To be genuinely hedged, you must have eliminated your price risk by having equal bushels owned (long) and sold (short) between the cash and/or futures markets. If these two sides of your balance sheet don’t match up, you are not fully hedged. While this may make sense for a producer as they offset a portion of their risk at a time and are often not fully hedged, it’s a bad business practice in the elevator world.

At the elevator, I always operated under a simple rule for when to hedge grain. Always. When I bought grain, I immediately sold futures, and when I sold grain, I bought futures (by using futures exchange whenever possible). There are plenty of risks and unknowns that come along with running a grain elevator, and futures price movement was not going to be one of them.

From time to time, I will hear an elevator say something like, “we try to stay pretty much hedged.” As Yoda said in The Empire Strikes Back, “Do, or do not. There is no try.” If you are committed to being a price neutral basis trader, you will not be “pretty much hedged.” My colleagues and I at White Commercial work with commercial grain elevators around North America on all facets of basis trading, but all of the principles we use work off of the assumption that you are entirely hedged. You cannot accurately track an average buy basis, understand your spread exposure or opportunities or determine potential basis margin if you have bushels at price risk.

Every elevator should have a hedging policy that states how many bushels they are willing to have at price risk and how they will monitor them. It should be an important part of someone’s daily routine to ensure that the elevator is indeed properly hedged. Monitoring hedged bushels allows you to find any possible mistakes quickly, so they can be corrected, hopefully before a market move can bite you.

Many companies will set their price risk threshold at 2,500 bushels (half a futures contract). This level makes sense, as you cannot be any more restrictive when hedging in 5,000-bushel increments. I understand the reluctance of many elevators (particularly large volume ones) to use mini (1,000 bushel) contracts as they tend to cost more to hedge, have less liquidity and may be more hassle than they are worth on high volume commodities. They may, however, have their place for commodities that are often bought infrequently or in smaller quantities and on purchases for deferred periods. I have had multiple conversations discussing the value of using mini contracts as opposed to staying unhedged on a couple of thousand bushels of new crop beans for a few weeks as the market drops.

Eliminating price risk by balancing your long and short positions is the foundation of basis trading.

Focus on basis

Once you have a routine in place to keep the elevator in balance and devoid of price risk, you are free to shift your focus to where you make your money: basis and spreads.

I started my first job in grain shortly before fall harvest with very little understanding of basis trading. We had quite a few bushels of corn bought on forward contracts for harvest delivery. Trying to get a feel for how these contracts compared to the current price, I asked the previous merchandiser for the average contracted price. He quickly answered -50 Dec.

When I clarified that I wanted to know the average cash price, he explained that he had no idea. His remark surprised me at the time, but it was one of my initial light bulb moments in understating what it meant to be a basis trader. My perception of grain values began the shift from cash price to basis.

For the basis trader, the futures price is simply a tool to set basis on cash transactions. The less energy you expel speculating on how futures may move, the better off you’ll be.

Instead, focus on how you can make money on basis movement and trends. Study the local basis history. Track the local basis along with your average basis ownership and sales. Work to set your buy basis to be both competitive and profitable. Learn the local buyers’ needs and tendencies to negotiate good basis sales. Anticipate your grain flow and work to set spreads that will allow you to carry out your plan. These practices build the skills of successful basis traders.

The elevator’s success is closely tied to its ability to shift focus from futures prediction to basis trading skills. None of these skills will help, however, without a balanced position to remove futures price risk. ■

Tracy Henkel is a grain merchandising specialist with White Commercial Corp. He helps grain elevators across North America maximize their merchandising opportunities and strengthen their relationship with producers through profit-based grain origination. He can be reached at [email protected] or follow him on twitter @thenkelWCC.

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