Hedging Against Rising Aluminum Prices using Aluminum Futures

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Good Choice for Beginners!
    Free Trading Education, Free Demo Account!
    Get a Sign-Up Bonus Now!

  • Binomo
    Binomo

    2nd in our ranking!

Contents

Hedging Against Rising Aluminum Prices using Aluminum Futures

Businesses that need to buy significant quantities of aluminum can hedge against rising aluminum price by taking up a position in the aluminum futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of aluminum that they will require sometime in the future.

To implement the long hedge, enough aluminum futures are to be purchased to cover the quantity of aluminum required by the business operator.

Aluminum Futures Long Hedge Example

An aluminum mill will need to procure 2,500 tonnes of aluminum in 3 months’ time. The prevailing spot price for aluminum is USD 1,470/ton while the price of aluminum futures for delivery in 3 months’ time is USD 1,500/ton. To hedge against a rise in aluminum price, the aluminum mill decided to lock in a future purchase price of USD 1,500/ton by taking a long position in an appropriate number of LME Aluminum futures contracts. With each LME Aluminum futures contract covering 25 tonnes of aluminum, the aluminum mill will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the aluminum mill will be able to purchase the 2,500 tonnes of aluminum at USD 1,500/ton for a total amount of USD 3,750,000. Let’s see how this is achieved by looking at scenarios in which the price of aluminum makes a significant move either upwards or downwards by delivery date.

Scenario #1: Aluminum Spot Price Rose by 10% to USD 1,617/ton on Delivery Date

With the increase in aluminum price to USD 1,617/ton, the aluminum mill will now have to pay USD 4,042,500 for the 2,500 tonnes of aluminum. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the aluminum futures price will have converged with the aluminum spot price and will be equal to USD 1,617/ton. As the long futures position was entered at a lower price of USD 1,500/ton, it will have gained USD 1,617 – USD 1,500 = USD 117.00 per tonne. With 100 contracts covering a total of 2,500 tonnes of aluminum, the total gain from the long futures position is USD 292,500.

In the end, the higher purchase price is offset by the gain in the aluminum futures market, resulting in a net payment amount of USD 4,042,500 – USD 292,500 = USD 3,750,000. This amount is equivalent to the amount payable when buying the 2,500 tonnes of aluminum at USD 1,500/ton.

Scenario #2: Aluminum Spot Price Fell by 10% to USD 1,323/ton on Delivery Date

With the spot price having fallen to USD 1,323/ton, the aluminum mill will only need to pay USD 3,307,500 for the aluminum. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the aluminum futures price will have converged with the aluminum spot price and will be equal to USD 1,323/ton. As the long futures position was entered at USD 1,500/ton, it will have lost USD 1,500 – USD 1,323 = USD 177.00 per tonne. With 100 contracts covering a total of 2,500 tonnes, the total loss from the long futures position is USD 442,500

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Good Choice for Beginners!
    Free Trading Education, Free Demo Account!
    Get a Sign-Up Bonus Now!

  • Binomo
    Binomo

    2nd in our ranking!

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the aluminum futures market and the net amount payable will be USD 3,307,500 + USD 442,500 = USD 3,750,000. Once again, this amount is equivalent to buying 2,500 tonnes of aluminum at USD 1,500/ton.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the aluminum buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising aluminum prices while still be able to benefit from a fall in aluminum price is to buy aluminum call options.

Learn More About Aluminum Futures & Options Trading

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Hedging Against Rising Aluminum Prices using Aluminum Futures

Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.

For stock options, each contract covers 100 shares.

Buying Put Options

Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.

A Simplified Example

Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.

Let’s take a look at how we obtain this figure.

If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don’t own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.

This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.

Protective Puts

Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts.

Selling Put Options

Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.

Covered Puts

The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying.

Naked Puts

The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.

For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.

Put Spreads

A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader’s maximum loss at the expense of capping his potential profit at the same time.

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Hedging Against Falling Aluminum Prices using Aluminum Futures

Aluminum producers can hedge against falling aluminum price by taking up a position in the aluminum futures market.

Aluminum producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of aluminum that is only ready for sale sometime in the future.

To implement the short hedge, aluminum producers sell (short) enough aluminum futures contracts in the futures market to cover the quantity of aluminum to be produced.

Aluminum Futures Short Hedge Example

An aluminum mining firm has just entered into a contract to sell 2,500 tonnes of aluminum, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of aluminum on the day of delivery. At the time of signing the agreement, spot price for aluminum is USD 1,470/ton while the price of aluminum futures for delivery in 3 months’ time is USD 1,500/ton.

To lock in the selling price at USD 1,500/ton, the aluminum mining firm can enter a short position in an appropriate number of LME Aluminum futures contracts. With each LME Aluminum futures contract covering 25 tonnes of aluminum, the aluminum mining firm will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the aluminum mining firm will be able to sell the 2,500 tonnes of aluminum at USD 1,500/ton for a total amount of USD 3,750,000. Let’s see how this is achieved by looking at scenarios in which the price of aluminum makes a significant move either upwards or downwards by delivery date.

Scenario #1: Aluminum Spot Price Fell by 10% to USD 1,323/ton on Delivery Date

As per the sales contract, the aluminum mining firm will have to sell the aluminum at only USD 1,323/ton, resulting in a net sales proceeds of USD 3,307,500.

By delivery date, the aluminum futures price will have converged with the aluminum spot price and will be equal to USD 1,323/ton. As the short futures position was entered at USD 1,500/ton, it will have gained USD 1,500 – USD 1,323 = USD 177.00 per tonne. With 100 contracts covering a total of 2500 tonnes, the total gain from the short futures position is USD 442,500

Together, the gain in the aluminum futures market and the amount realised from the sales contract will total USD 442,500 + USD 3,307,500 = USD 3,750,000. This amount is equivalent to selling 2,500 tonnes of aluminum at USD 1,500/ton.

Scenario #2: Aluminum Spot Price Rose by 10% to USD 1,617/ton on Delivery Date

With the increase in aluminum price to USD 1,617/ton, the aluminum producer will be able to sell the 2,500 tonnes of aluminum for a higher net sales proceeds of USD 4,042,500.

However, as the short futures position was entered at a lower price of USD 1,500/ton, it will have lost USD 1,617 – USD 1,500 = USD 117.00 per tonne. With 100 contracts covering a total of 2,500 tonnes of aluminum, the total loss from the short futures position is USD 292,500.

In the end, the higher sales proceeds is offset by the loss in the aluminum futures market, resulting in a net proceeds of USD 4,042,500 – USD 292,500 = USD 3,750,000. Again, this is the same amount that would be received by selling 2,500 tonnes of aluminum at USD 1,500/ton.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the aluminum seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling aluminum prices while still be able to benefit from a rise in aluminum price is to buy aluminum put options.

Learn More About Aluminum Futures & Options Trading

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Hedging Against Rising Copper Prices using Copper Futures

Businesses that need to buy significant quantities of copper can hedge against rising copper price by taking up a position in the copper futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of copper that they will require sometime in the future.

To implement the long hedge, enough copper futures are to be purchased to cover the quantity of copper required by the business operator.

Copper Futures Long Hedge Example

A copper fabricator will need to procure 2,500 tonnes of copper in 3 months’ time. The prevailing spot price for copper is USD 3,171/ton while the price of copper futures for delivery in 3 months’ time is USD 3,200/ton. To hedge against a rise in copper price, the copper fabricator decided to lock in a future purchase price of USD 3,200/ton by taking a long position in an appropriate number of LME Copper ‘A’ Grade futures contracts. With each LME Copper ‘A’ Grade futures contract covering 25 tonnes of copper, the copper fabricator will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the copper fabricator will be able to purchase the 2,500 tonnes of copper at USD 3,200/ton for a total amount of USD 8,000,000. Let’s see how this is achieved by looking at scenarios in which the price of copper makes a significant move either upwards or downwards by delivery date.

Scenario #1: Copper Spot Price Rose by 10% to USD 3,488/ton on Delivery Date

With the increase in copper price to USD 3,488/ton, the copper fabricator will now have to pay USD 8,720,250 for the 2,500 tonnes of copper. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the copper futures price will have converged with the copper spot price and will be equal to USD 3,488/ton. As the long futures position was entered at a lower price of USD 3,200/ton, it will have gained USD 3,488 – USD 3,200 = USD 288.10 per tonne. With 100 contracts covering a total of 2,500 tonnes of copper, the total gain from the long futures position is USD 720,250.

In the end, the higher purchase price is offset by the gain in the copper futures market, resulting in a net payment amount of USD 8,720,250 – USD 720,250 = USD 8,000,000. This amount is equivalent to the amount payable when buying the 2,500 tonnes of copper at USD 3,200/ton.

Scenario #2: Copper Spot Price Fell by 10% to USD 2,854/ton on Delivery Date

With the spot price having fallen to USD 2,854/ton, the copper fabricator will only need to pay USD 7,134,750 for the copper. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the copper futures price will have converged with the copper spot price and will be equal to USD 2,854/ton. As the long futures position was entered at USD 3,200/ton, it will have lost USD 3,200 – USD 2,854 = USD 346.10 per tonne. With 100 contracts covering a total of 2,500 tonnes, the total loss from the long futures position is USD 865,250

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the copper futures market and the net amount payable will be USD 7,134,750 + USD 865,250 = USD 8,000,000. Once again, this amount is equivalent to buying 2,500 tonnes of copper at USD 3,200/ton.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the copper buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising copper prices while still be able to benefit from a fall in copper price is to buy copper call options.

Learn More About Copper Futures & Options Trading

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Testing Your Metal: Hedging to Manage Price Risk

The copper market provides an excellent example and is representative of the base metals complex overall. Following the bursting of the dotcom bubble in 2000 and the onset of economic weakness, the spot price of copper on the New York Commodity Exchange fell to 60¢ per pound in November 2001, as global demand fell precipitously, causing inventories to rise to record high levels. Although the outlook at the time was decidedly bearish, with expectations of depressed prices for years to come, the copper market inexplicably began showing signs of strength.

Initially it was not clear what was driving the markets in early 2002, but before too long, it became apparent that China was embarking upon a long-term growth plan that would require massive quantities of all industrial raw materials to support its ambitious programs. Indeed, China surpassed the United States as the world’s largest consumer of copper among other metals that year, with its share of global consumption today in excess of 40%.

Coincident with the stronger fundamental environment sparked by China and reinforced by a global economic recovery, inventories of metal fell sharply, causing prices to begin trending higher. By the end of 2003, the price of copper had reached $1.00 per pound, with the base metals complex overall moving up. Along with the vastly improved outlook, speculative trading also accelerated as did market volatility.

By May 2006, the monthly average price of copper on Comex had risen to $3.75, up $3.15 or almost 500% from just five years earlier, while the daily Spot price traded well over $4.00 per pound. The price of aluminum on the London Metals Exchange more than doubled from 58¢ to $1.30 within the same period, while zinc saw a near five-fold increase, rising from 34¢ in 2001, to $2.00 by 2006.

As we know only too well, however, nothing goes up indefinitely and as the financial crisis unfolded in 2008 with panic selling in all markets, prices fell unrelentingly, taking a severe toll on many organizations and putting some out of business entirely, with their lenders also incurring significant losses.

What lessons can we learn from these events? First and foremost, it is incumbent upon any lender, and particularly those providing asset-based financing, to insure their loans are protected. Just as any lender requires a homebuyer to carry insurance as protection against losses before a mortgage is issued, so too should a financial institution require that its client have an adequate price protection plan or hedging program in place.

While hedging is one of the most important aspects of price risk management, it is also one of the least understood tools available to an organization. Further, while on the surface hedging is very straightforward, often times it is mistakenly confused with speculating.

For example, with copper trading today at $3.50 per pound, a producer with its cost of production at say $1.50 per pound is enjoying a gain of $2.00 for every pound produced. If the company wanted to lock in the gain on some portion of its production, it could do so by selling forward, or establishing a short position in the futures market. If the market subsequently rises, it will not participate in the gain but will have locked in a profit. Alternatively, that same producer may take the view that with prices well above the cost of production it has no interest in hedging. Thus, if the market declines, it will experience an opportunity loss until the price falls to the $1.50 level, beyond which it becomes a cash loss. Therefore, the question of whether a producer should hedge or speculate on prices depends not only on its cost of production, but also on the operating philosophy of senior management, in conjunction with the conditions of its borrowing terms.

Manufacturing companies on the other hand face very different circumstances, with the elements of market risk exposure varying across the sector depending on how closely aligned the price of their product is to changes in metal market prices. For instance, the price of a car will not change from day to day regardless of changes in the price for copper, aluminum, lead, tin, nickel or zinc, all of which are contained in an automobile.

A wire and cable manufacturing company, or brass mill, on the other hand experiences an immediate impact from daily movements in metal prices. This is because typically its selling price, as well as inventory valuation, is tied directly or indirectly to Comex or London Metals Exchange prices. In the simplest of terms, once a company in this category buys metal for production, or holds metal in inventory, it is facing market risk until the finished product is sold.

To protect against falling prices a company can employ a number of approaches to mitigate the risk. Ultimately, the objective is to establish an offsetting position to their physical metal. This can be accomplished by entering into “firm fixed priced” sales to its customers, establishing a short position by selling futures contracts or purchasing price insurance in the form of a put option.

With each alternative, there are benefits as well as drawbacks that must be weighed to determine the appropriate course of action.

Entering into a firm priced sale with customers is the most straightforward approach, but in all likelihood, the total of these sales will not be enough to reduce all of the exposure. Additionally, the company faces the risk of its customer failing to meet its purchase obligation for any number of reasons.

Using the futures market to manage price risk exposure provides the most flexible and strongest level of protection as the exchanges stand behind and guarantees all trades. It must be recognized though, that cash is required to support a futures position in the form of initial margin, or a good faith deposit, as well as variation margin if the futures account falls into deficit when it is marked to the market on a daily basis.

It will also be necessary to learn the “mechanics of the market” in order to understand the implications of contract expiration, for example, and terms such as contango and backwardation which represent the market structure and will have a direct bearing on the outcome of the hedging program.

The use of options as a hedging strategy should be viewed as buying price insurance. That is to say, by paying a premium, or the cost of the option, one can protect a specific price, for a specific period of time. Also, while futures contracts create an obligation to close out the contract subsequent to it being entered into, options provide the right, but not the obligation, to offset the initial transaction.

There are many other aspects of both futures and options that require further explanation to gain a deeper understanding of these instruments, but the key point here is to highlight how they can be used to manage price risk.

The following examples will help to illustrate how the futures market can be used to mitigate a company’s price risk exposure on inventories.

In the example below, the market is in a contango structure wherein the forward months are at a premium to the nearby month. By selling a forward month, the contango is locked in, helping to offset the cost of financing, while at the same time compensating for the decline in price.

Example 2 demonstrates the impact of a backwardation market structure wherein forward prices trade at a discount to nearby values. In this instance, while the overall hedge resulted in a net loss of 5¢ due to the backwardation, if no hedge had been in place, the company would have experienced a 30¢ loss.

Of course, if market values from the financial crisis of 2008 were used, the impact would have been more dramatic as copper fell $2.83, or almost 70% from $4.08 on July 2, to $1.25 on December 24. More recently, the price of copper fell from $4.19 at the end of August 2020 to $3.14 on September 30 representing a $1.05, or 25% loss of value in just one month, with other metals also sharply lower. And given the continued erratic movements in most markets of late, it appears volatility will remain with us going forward.

It cannot be emphasized enough that price risk can and will have a significant impact upon an organization’s profitability and by extension the profitability of their lender.

Here are a few questions you should consider when reviewing an asset-based loan:

  • Is there a clear understanding of the difference between speculating and hedging?
  • Have reports been created to summarize and assess price risk exposure?
  • Has a plan been developed to hedge price risk?
  • Are you able to independently test and verify the exposure of the company?
  • Does the credit facility recognize the potential need for cash to support a hedging program?

There are many other considerations to be taken into account, but the issue here is to establish a clear understanding of market risk and how it will be controlled. With a properly structured hedging plan in place, you can be confident that your client and your asset-based loan will be protected.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Good Choice for Beginners!
    Free Trading Education, Free Demo Account!
    Get a Sign-Up Bonus Now!

  • Binomo
    Binomo

    2nd in our ranking!

Like this post? Please share to your friends:
How To Start Binary Options Trading 2020
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: