Commodities

Futures Markets and Offsetting Price Risk

dondawson
Don Dawson
Instructor

Futures markets exist for the purposes of price discovery (facilitation of trade) and transferring risk to counterparties (hedgers trading with speculators). The optimal condition for this price discovery is having a central Exchange where buyers and sellers can meet in a price competitive environment. These Exchanges also create contract specifications and create rules that are available to all traders before they place any trades. This way everybody is aware of exactly what price points and quality of the Commodity they are trading will be in advance of any transaction.

There are many different Futures markets, but I will be using the Wheat market for this particular article.  Any Futures trader with a trading account at a Futures Commission Merchant (FCM) may participate in this daily price discovery process.  Any trader who does not use the Wheat product in their daily business will be classified as a non-commercial large or small speculative trader.  Market participants that actively use Wheat are classified as a Commercial or Hedger participant.  Commercial traders usually have Futures positions opposite of their Cash position.  Producers of Commodity products are usually short Futures contracts.  Processors of Commodity products are usually long Futures contracts.  A Commercial traders objective is not to speculate, but to merely offset price risk to lock in a profit margin.  Speculators on the other hand are looking to anticipate the market’s direction and bet whether the market will rise or fall.

A Futures participant can also use Options to speculate or hedge with.  If you believe Wheat will rise you can purchase a Call Option or Sell a Put Option.  If you believe prices will fall you can purchase a Put Option or sell a Call Option.  A long Call (Put) Option is the right, but not the obligation, to go long (short) the underlying Future contract at the Strike price at or before expiration.  A short Call (Put) Option is the obligation to deliver (take delivery of ) the underlying Future at or by the expiration if that Option is exercised.

Commercials / Hedgers often use Wheat Options.  Producers of Wheat can set a floor beneath a selling price with long Put Options.  Processors can set a ceiling above their costs to process with long Call Options.  Obviously there are many other sophisticated ways of using Options strategies that are available to all market participants.

The cost trade in the Futures markets is minimal.  For each Futures contract a Speculator or Hedger uses they will post an initial margin amount for the first trading day they carry the position over from a day trade.  These margins are set and monitored by each Futures Exchange that the Futures contract trades on.  After the initial margin requirement is met and the trader wishes to hold the position for more than one day the trader will have a maintenance margin to meet.  Maintenance margins are less than initial margins and the difference between the two is then deposited back into the traders account to be used for other transactions.  If the trader is using Options there is no margin for long Options positions, but if they are short the Options there will be a margin requirement.  While holding long or short Futures positions if the market moves in your favor you can take the open equity profits out of your account down to the maintenance level of cash in your account.  Each Futures contract is marked-to-the-market daily thereby making your funds available daily.

If you continue to hold a Futures contract that adversely moves against you and your account balance does fall below the maintenance level you will receive a margin call.  These usually come from your broker or FCM requiring you to replenish your account with cash back up to the initial margin requirement.  Or if you do not replenish the account the broker/FCM will liquidate your open position and deposit the remaining funds back into your account.  If a trader does enter a position and the margin increases while the position is open you are still required to have the new higher margin per contract in your account.

Futures Exchanges act as counterparty intermediaries.  They will guarantee all Futures contracts are honored if there is a default by the other party in the transaction.  There is always a buyer and a seller in each transaction and either party may be at risk of default for numerous reasons.

As mentioned in the beginning risk transfer is the second purpose of the Futures markets.  Any producer (grower or grain elevator) of Wheat, or Processor of Wheat (processes Wheat for human or animal consumption) can gain access to the Futures markets to protect against price changes that could reduce their profit margins in their respective businesses.

The mechanics for both types of Hedgers are identical.  A Wheat Producer at risk to prices falling can acquire a short Futures position which will rise in value as the prices fall.  For the Processor they can obtain a long Futures position that will rise in value as prices rally, allowing the Processor to use the profits from this Futures transaction to offset the higher cash price when they need it for processing.

Even Hedgers cannot plan the perfect Hedge all the time.  During the life of the Hedge something called “Basis” can impact their Hedges.  Basis is the difference between the cash crop of Wheat and the Futures contract being used to deliver or Hedge with.  Items like storage facility cost, transportation of the crop and interest rates to purchase the crop on credit can affect the Basis during a Hedge.

Due to these variables affecting the Basis a Hedger might have prices inadvertently go against his position and will need to meet margin calls (the need to replenish his account with cash) to maintain his Hedge.  This is where using long Options may be more beneficial to Hedge with.

Let’s face it, Commodity prices can be very volatile.  At times even a Hedger is scratching his head wondering where the price will stop moving up or down.  This is one of the reasons that Hedgers like to use long Options positions.

A Producer can use a long Put Option to protect their downside price risk.  By purchasing the Put the Hedger can only lose what premium they pay for the right to own a short Futures position at the Strike price selected at the time of Option purchase.  In the event the Wheat market continues to rally (Producer technically is long the Cash Wheat market because he owns the crop) for some unknown reason the Hedger will only lose his Option premium paid, but will not have to face margin calls if he had a short Futures contract as a Hedge.  As prices rally the Hedger can possibly offset his Options premium losses by the higher prices in the Wheat market that he will regain at harvest time.

A Processor can use a long Call Option to protect their upside price risk.  Processors like to buy a Commodity as cheaply as possible to help increase their profit margin after processing the product and selling it.  If a Commodity has a supply shortage the price can rally quickly causing the Processor to have to pay much higher prices for the Commodity when they need it for Processing.  These higher prices are then passed on to you and I the consumer of the product.  By purchasing the Call the Hedger can only lose what premium they pay for the right to own a long Futures position at the Strike price selected at the time of the Option purchase.  For the Processor if the prices fall they will be able to purchase the Commodity at a much cheaper price later in the cash market.  If the price falls far enough the Hedger will recoup their premium loss back from what they save on buying the Commodity later.  The Processor is protected from margin calls from Futures contracts because they purchased Call Options instead to Hedge with.

These were some very simplistic examples of how a Hedger might use the Options market to Hedge their price risk.  The biggest advantage to buying the option is the limited risk of just the premium they paid.  If a Hedger shorts an Option there is unlimited risk for a limited profit potential.

Options can become complex quickly by being influenced by variables including time remaining to contract expiration (time value), underlying Commodity volatility (speed of market price changes), interest rates can impact Options premiums and then there are the “Greeks” of Options.  Understanding Delta, Gamma, Intrinsic Values etc…..  I would strongly recommend attending one of our Options classes at Online Trading Academy to better know how to use Options to your advantage if you do not thoroughly understand Options.

“People rarely succeed unless they have fun in what they are doing.”  Dale Carnegie

– Don Dawson

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.