Barchart.com Hedging Risks with Futures

Hedging Risks with Futures and Options

Eero A. Pikat President

, Inc.



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Disclosure

WARNING: FUTURES AND OPTION TRADING INVOLVES HIGH RISKS AND YOU CAN LOSE A LOT OF MONEY.

When investing in futures, you may lose more than the funds you invested. When purchasing options, you may lose all of the money you invested.

Trading on commodity futures or options involves substantial risk of loss. According to many experts, most individual investors who trade commodity futures or options lose money.

Being a successful PAPER TRADER during one time period does not mean that you will make money when you actually invest during a later time period. Market conditions constantly change.

Notice: Hypothetical or simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since the trades have not actually been executed, the results may have under- or over- compensated for the impact, if any, of certain market factors, such as lack of liquidity. Hypothetical trading results are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown.

If you are trading options, the futures charts are presented for informational purposes only. They are intended to show how investing in options can depend on the underlying futures prices; specifically, whether or not an option purchaser is buying an in-the-money, at-the-money, or out-of-the-money option. Furthermore, the purchaser will be able to determine whether or not to exercise his right on an option depending on how the option's strike price compares to the underlying futures price. The futures charts are not intended to imply that option prices move in tandem with futures prices. In fact, option prices may only move a fraction of the price move in the underlying futures. In some cases, the option may not move at all or even move in the opposite direction of the underlying futures contract.

What are Commodities?

Things that are mined and/or drilled for

Oil, Natural Gas Metals

Things that grow

Food (Corn, Soybeans, ...) Fiber (Lumber, Cotton, ....)

Futures vs Commodities

Commodities Cash (Spot) Market

Jewelry store for gold Grain elevator for corn Gas station for gas

(Generally) unregulated, lots of differences in price, quality, availability, etc.

Futures Markets

Regulated, centralized trading where quantity, quality (grade), delivery, dates are fully specified

Example: 1,000 barrels of Light Sweet Crude Oil, delivered at any pipeline or storage facility in Cushing, Oklahoma, which has pipeline access to TEPPCO, Cushing Storage, or Equilon Pipeline company

In short: highly specific trading unit

Futures expanded to "non-commodities" such as Dow Jones Futures, Interest Rates, Currencies

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Mature Markets Intertwined

Mature markets co-mingle futures vs. cash Ex: WTI Crude Oil price is actually the one on

NYMEX, same with Gold Grain Merchandisers at grain elevators use

CBOT Corn price to determine their own prices Why?

Uniform centralized price, absent of individual variances such as transportation costs, taxes, etc.

Hedging

What is hedging?

Reducing or eliminating risk (exposure) to market prices

Why do you want to hedge?

If you do NOT want to introduce market risk into your revenue/costs

Hedging

Who should hedge?

Anyone who wants to maintain risk-neutrality on market prices

Airlines for gas prices Firms with foreign customers paying in

different currencies Manufacturing firms with exposure to raw

materials, precious metals Food companies

How?

Futures Contract

Specified Quantity Specified Quality Specified Place & Date of Delivery

Contract Value = Quantity x Price

Gold: $1,700 / oz x 100 oz = $170,000 Mini Copper ? 12,500 lbs x 3.30 = $41,250 Micro CAD/USD - $10,000 x .9802 = $9,802

Futures Hedge

Find a contract that most closely matches your position, and buy/sell it

In general, you can "buy ahead" or "sell ahead". So if you know you will be using 25,000 lbs of copper, you can buy it now. If someone is paying you 1,000,000 next year, you can sell them for U.S. Dollars now.

Difficulties matching size with need. The smallest copper contract is 12,500 lbs.

Sometimes there are complementary commodities: construction vs. weather

Futures Examples

Let's say a Canadian customer wants to pay you CAD$25,000 for a project. Currently, the price is .98 to 1 USD. That's $25,510 USD. But as recently as July, the CAD was at $1.05, which is $23,800. That's a $710 swing. To hedge:

? "Buy the Canadian Dollar" (or "sell" the US Dollar today). ? 2 E-Micro contracts. It's the same as buying CAD$20,000

today. So if the $USD goes down, you only lose 20% of what you would have lost.

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Options

Alternative to Futures Ability to accept (some) risk in return for

reduced premium 1 options contract converts to 1 futures contract You buy the "right to buy" (call) or the "right to

sell" (put) at a preset price You pay a premium for this right

Options Example

On 9/25, when I created this slide, Gold was trading at $1,640

A $1,700 call was selling for $6,540 So, to protect yourself from gold going through the roof, it

would cost you $12,540. $1,700 ? $1,640 = 60 x 100 = $6,000 + $6,540 Now if gold goes to $1,900, instead of losing $260 x 100 = $26,000, you only lose $12,540 If gold goes down, you are out the $6,540. It's essentially insurance Need to find right mix of price vs. premium vs. risk

Hybrid Futures + Option

Let's say you need to buy 1,000 lbs of copper in December Problem: Main copper contract is 10,000 lbs Solution: Buy 1 copper contract, sell 1 put option Example: Copper is trading at $3.30 / lb You would be paying about $3,300 for the copper Find a Put option at around this price. Currently, there happens to be

one at $3.28. This is the right to sell the copper at $3.28. Buy the copper futures. If the futures go up, you gain, cent for cent. If

the futures go down, your max loss is at $.02 x 25,000 or $500. (You would have paid the $3,300 anyway).

Summary

Use futures to fully offload risk. If you know you are going to be buying a specified quantity, and you need to price in today's dollars, buy it in today's dollars. If you know you are going to be selling something in the future, you can sell it in today's dollars

Use options as a form of insurance, where you pay a premium to lock in and limit your market exposure

If the price goes against you, that's fine. You are not a speculator. That's a different market, a different business. If you are in construction, why on earth are you speculating on interest rates, raw materials, etc. You shouldn't be trying to make money in the markets unless that's your business. Not having a proper hedge means that you are trying to make money in the markets, hoping copper goes down so that you pay less for it than what you quoted on a contract.

A good broker can help you find the right risk/reward

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