I get it when farmers tell me how much they dislike commodity hedge funds (aka managed money) and their outsized influence on the market. It seems like the funds buy little by little, slowing down the rise of prices, and then they suddenly dump all their long positions at once, causing prices to plummet. Unlike other market participants who enter the market to turn your production into valuable products, it feels like hedge funds are just speculators trying to make a fast buck off your hard work. I’m not going to argue this with anyone, because, big picture, it’s true (and, really, aren’t we all in this to make money?). Although some of you have been wishing managed money away, I’m going to give you insight into how hedge funds and farmers interact, how that can affect prices, and the role they play in getting you a better price.
How Hedge Funds Might Be Financing Your Forward Sales in a Favorable Market
Let’s say prices look decent, and you think it’s a good time to make a sale on your grain in the field. You approach your co-op and enter into an agreement to sell grain based on the futures price and basis. To avoid market risk, your co-op doesn’t hold the futures portions on their books. Instead, they turn around and sell it immediately – and odds are good – to a hedge fund. Yes, a hedge fund. One of the reasons you could make the sale you wanted to make at a price that looked good is because a hedge fund was there to buy your position.
While that’s good, why do prices seem to rise slowly in an up market? Both hedge funds AND farmers play a role in that. Let’s dive into farmer and hedge fund behaviors that support this phenomenon.
- The availability of hedge fund participation in the market makes it more likely for a buyer to be available when you want to make a sale (more liquidity!!).
- More potential buyers when hedge funds are seeing upside potential translates to continued higher prices.
In this example, the number of buyers in the market is up. Why don’t we see a quick run-up in price? The quick answer is the built-in brake that slows down price increases.
- Managed money is interested in leveraging the perceived value of a particular grain – both upwards and downwards, and thus holds both long and short positions. Clearly, in a rising market, you can expect managed money to be net buyers and long to take advantage of rising markets. The key word here is “net”. While many funds go long (that is, are buyers), other funds might sell to exit existing long positions and lock in gains or even take a short position on a bet the market might fall. This means that hedge funds, as a whole, are potentially offsetting some of their buys in the market with sales in the market.
- Farmers collectively don’t hold everything until prices rise to a certain level (which would, in essence, put more upward pressure on prices) and then sell all at once. They do it little by little, and prices rise at a pace that tends to match the slow discovery of people able or willing to sell.
To sum it up, farmers benefit from hedge fund participation in the market because they make it easier for you to make the sales you want at a better price. However, between that participation and the pace of farmer sales, you can also expect a measured ramp-up of prices. So what’s going on in a down market and why does it feel as if prices fall like a brick?
How Hedge Funds and Farmers Might Accelerate Price Declines in a Down Market
Now let’s say the market is peaking. What sorts of behaviors can you expect?
- Remember how hedge funds were net buyers in a rising market? When the market turns, so do hedge funds as they become net sellers to lock in gains and go short to capitalize on a falling market. This puts downward pressure on prices, as the number of buyers decreases while the number of sellers increases. Depending on sentiment, this downward pressure can accelerate quickly if the relatively small number of hedge funds decide to go short rapidly.
- In contrast, remember how farmers are net sellers in a rising market? When the market turns, grain farmers continue to be net sellers, either by sitting tight or selling off inventory. Unlike hedge funds, they simply don’t play both sides of a transaction to influence the liquidity on the exchange as both a seller and a buyer.
Take a moment to think about this – in a rising market, hedge funds are buying what farmers are selling. In a down market, everyone is selling. This, in a nutshell, is why the market tends to go upwards slowly and downwards quickly. It has everything to do with a vastly unequal number of buyers in a down market vs. an up market, and the reality that farmers can collectively slow down a rising market, but not a falling market.
Be Aware of How These Behaviors Affect Your Own Marketing Decisions
Hedge funds create liquidity that help you garner better prices by increasing the number of buyers in the market. All in all, this allows you to capitalize on market potential that would be less readily available in a less liquid environment. However, with that advantage comes the need to adjust your own strategies accordingly. Some key elements to consider:
- Make incremental sales in a rising market. If you sell too much too quickly, you will lose the chance to garner a better price as the market rises. However, we know hedge fund participation can contribute to fast price declines, so you don’t want to make a bet on hitting the top of the market.
- Pay attention to extreme short or long managed money positions. They are both indicators that funds may want to start harvesting unrealized gains.
- If your analysis shows that you are close to the top of a market on unsold grain, yet aren’t quite ready to sell, consider buying puts to protect yourself from downside risk.
Next Month: Deep Dive into Reading Managed Money Charts
Now that we’ve talked about how managed money and farmers interact to affect market prices, the next step is to understand how you can track the movement of managed money as you set your own pricing strategy. Next month we’ll take a look at the charts and discuss how to use the information to your advantage.
In the meantime, if you have any questions about managed money or the markets in general, contact the TFM360 team at 800.334.9779. We look forward to discussing that and how we can help you set a pricing strategy suited to the needs of your operation.