Below is an excerpt from a weekly column called “A Scientific View” written by Hedge Plus owner Patrick Hayes. In this column dated February 24, 2025 Patrick explains why limiting loss is important beyond just the direct financial benefit.
On Thursday, a client called upset because futures rallied $.70, and he only added 58.3% to his investment and so he fired me. That was the first time in a while I have been fired for a recommendation that made money, what gives?
First, I get it. Most of us want to capture the whole move anytime one buys or sells futures, and the market moves in their direction. However, one needs to take equal risk and margin for that risk. We also need to look at all our risks and as farmers you have greater risk with cash sales than in your hedge accounts.
My recommendations on buybacks contain protection. Usually, I will recommend buying a put and paying for some of that put with a sold call. Protection limits risk but also limits reward.
The reason I think it is wise to limit the buyback risk is because of your overall risk when doing a buyback. A loss doing a buyback means that any sales in the future will be lower also. Any old crop and all unsold new crop will be at a lower price if you lose on a buyback. In addition, the bushels you are buying back will net a lower price because of the buyback loss.
Let’s say Farmer A buys back a $4.20 per bushel sale that he made of 30% of his crop. The market moves $.30 lower. Farmer A buy futures and exits the position with a $.30 loss. Not only has Farmer A turned that $4.20 sale into a net $3.90 sale, but all unsold old and new crop also has a lower selling price.
Buying a protective position still would have incurred a loss and a net decrease in cash crop sales. The key is that it would not have been a $.30 loss. My goal is to limit the loss to a third or less of the future’s contract move. Hypothetically, let’s assume protection cut the loss to $.10.
Why is limiting the loss important?
In the above example the client exited the position when a $.30 loss occurred. By limiting the loss to a $.10 loss using protection, the client is then more likely to stick with the long position, especially if the risk is fixed and known risk. Knowing what a position can lose allows better staying power. How many times have prices fallen hard only to recover after you exit a buyback? Having staying power allows for better management of short term losses and increases the probability of success.
My philosophy is that we need to take every advantage we can when doing buy backs even if that means limiting profit potential.