Over the past period, Giacaphe.com has introduced several methods for risk management in coffee trading, as well as tools to help farmers avoid the “good harvest, low price” dilemma, through articles by various authors.
However, the way the information has been presented may have been too technical and difficult to implement in practice. Therefore, the application of these strategies has not been widespread. Today, Y5Cafe would like to introduce an article by Kinh Vu that shares insights on this issue.
The Origins of Hedging in Buying and Selling
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As introduced in previous articles in our Coffee Market Knowledge section, the current online coffee market has been created by farmers themselves, which is why some terms come from the farmers’ vocabulary, such as the term “Hedge.” Originally, “Hedge” referred to fences or barriers built to prevent damage from wild animals or livestock from neighboring farms that might destroy crops.
Later, when applied to the market, the term “Hedge” (risk management) was used in a similar sense, aiming to protect the outcome of one’s labor (i.e., the product) from losing value due to negative market events, such as “good harvest, low price” situations, where the price might be lower during harvest season than at the time of planting.
Thinking About Risk
To better understand the method of risk management, some have likened it to buying insurance. When people decide to hedge in the market, it is similar to buying insurance to protect themselves against unforeseen events. Buying insurance does not prevent the unwanted event from happening, but if it does, the damage is mitigated. Applied to the coffee market, farmers can avoid severe price fluctuations when they wish to sell their products, even if they do not yet have the actual product.
This kind of thinking is very different from that of companies that have been in the coffee trading business for hundreds of years, which continue to thrive, compared to companies that only trade in one direction—speculating and making big profits, but at the risk of losing everything with a few failed bets.
A method of using futures markets to hedge against the risk of coffee being devalued during harvest months is something that farmers worldwide have been doing for hundreds of years. This was long before brokers had to wave their hands and shout prices on the floor of exchanges, which farmers today can avoid thanks to the internet. The only thing that needs to change is the way we think.
How Farmers Can Hedge Their Risk
Let’s take an example: Suppose a farmer is in March 2014 and sees that the November 2014 contract is priced at $2010. The farmer thinks that this price is good and hopes it remains the same when harvest season comes in November 2014. The farmer wants to secure this price before it potentially drops.
Alternatively, in mid-July, Brazil is entering winter, and this year’s weather is unpredictable. While the Northern Hemisphere is still experiencing snow in March, Brazil is suffering from a drought. A cold snap in July might lead to higher prices due to low stock levels. The farmer might wish to sell at the same price as the November contract, which they think is beneficial.
With the right mindset and a little research, we believe that Vietnamese coffee farmers can avoid having to sell their product at a loss when prices are high. Instead, large-scale farmers in Vietnam can sell futures contracts to protect their physical inventory, using a hedging strategy to avoid the “wishful thinking” scenario.
The Hedging Strategy
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Real Product for 2014/2015
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Futures Market
Results:
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In March 2014: The farmer has no coffee yet, but plans to harvest 10 tons in October and wants to sell it at the current November 2014 price of $2010.
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In October 2014: The farmer decides to buy back 10 tons of coffee for November 2014 at $1610.
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Profit from Futures Market: $2010 – $1610 = $400/ton to compensate for the loss on physical sales.
If the price increases to $2410 per ton in October:
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The farmer buys back 10 tons at $2410.
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Loss on Futures: $2010 – $2410 = -$400/ton, but the real sale is at the higher price.
Through this strategy, farmers are not trying to make extra money, but simply protecting what they’ve worked hard for by ensuring that the price at the time of harvest won’t be lower than expected. Without hedging, a farmer can still sell real product at $2410 (if the price goes up), but if the price falls to $1610, there is no compensation for the loss.
Additionally, the farmer has the entire harvest season to choose the best time to sell, while those not using hedging will have to sell once the harvest is complete. Naturally, when everyone sells at the same time, the price will be pressured down.
For agents and coffee traders who act as intermediaries for farmers, providing advance payments and agricultural supplies, this hedging strategy is effective in protecting against price drops at the end of the year.
While this method may not be practical for small-scale farmers, we’ve found that many families with 5 hectares or more of land can participate in futures markets. With the help of some banks and online futures platforms, the basic hedging strategy is a simple tool that farmers can use.
In upcoming articles, we will cover the procedures for participating, market laws, and basic knowledge for engaging in futures trading.