Hedging Against Falling Cotton Prices using Cotton Futures

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Contents

Hedging Against Falling Cotton Prices using Cotton Futures

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

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

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

Cotton Futures Short Hedge Example

A cotton grower has just entered into a contract to sell 5.00 million pounds of cotton, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of cotton on the day of delivery. At the time of signing the agreement, spot price for cotton is USD 0.4600/lb while the price of cotton futures for delivery in 3 months’ time is USD 0.4600/lb.

To lock in the selling price at USD 0.4600/lb, the cotton grower can enter a short position in an appropriate number of NYMEX Cotton futures contracts. With each NYMEX Cotton futures contract covering 50,000 pounds of cotton, the cotton grower will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the cotton grower will be able to sell the 5.00 million pounds of cotton at USD 0.4600/lb for a total amount of USD 2,300,000. Let’s see how this is achieved by looking at scenarios in which the price of cotton makes a significant move either upwards or downwards by delivery date.

Scenario #1: Cotton Spot Price Fell by 10% to USD 0.4140/lb on Delivery Date

As per the sales contract, the cotton grower will have to sell the cotton at only USD 0.4140/lb, resulting in a net sales proceeds of USD 2,070,000.

By delivery date, the cotton futures price will have converged with the cotton spot price and will be equal to USD 0.4140/lb. As the short futures position was entered at USD 0.4600/lb, it will have gained USD 0.4600 – USD 0.4140 = USD 0.0460 per pound. With 100 contracts covering a total of 5000000 pounds, the total gain from the short futures position is USD 230,000

Together, the gain in the cotton futures market and the amount realised from the sales contract will total USD 230,000 + USD 2,070,000 = USD 2,300,000. This amount is equivalent to selling 5.00 million pounds of cotton at USD 0.4600/lb.

Scenario #2: Cotton Spot Price Rose by 10% to USD 0.5060/lb on Delivery Date

With the increase in cotton price to USD 0.5060/lb, the cotton producer will be able to sell the 5.00 million pounds of cotton for a higher net sales proceeds of USD 2,530,000.

However, as the short futures position was entered at a lower price of USD 0.4600/lb, it will have lost USD 0.5060 – USD 0.4600 = USD 0.0460 per pound. With 100 contracts covering a total of 5.00 million pounds of cotton, the total loss from the short futures position is USD 230,000.

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In the end, the higher sales proceeds is offset by the loss in the cotton futures market, resulting in a net proceeds of USD 2,530,000 – USD 230,000 = USD 2,300,000. Again, this is the same amount that would be received by selling 5.00 million pounds of cotton at USD 0.4600/lb.

Risk/Reward Tradeoff

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

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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 Cotton Prices using Cotton Futures

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

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

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

Cotton Futures Long Hedge Example

A textile mill will need to procure 5.00 million pounds of cotton in 3 months’ time. The prevailing spot price for cotton is USD 0.4600/lb while the price of cotton futures for delivery in 3 months’ time is USD 0.4600/lb. To hedge against a rise in cotton price, the textile mill decided to lock in a future purchase price of USD 0.4600/lb by taking a long position in an appropriate number of NYMEX Cotton futures contracts. With each NYMEX Cotton futures contract covering 50000 pounds of cotton, the textile 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 textile mill will be able to purchase the 5.00 million pounds of cotton at USD 0.4600/lb for a total amount of USD 2,300,000. Let’s see how this is achieved by looking at scenarios in which the price of cotton makes a significant move either upwards or downwards by delivery date.

Scenario #1: Cotton Spot Price Rose by 10% to USD 0.5060/lb on Delivery Date

With the increase in cotton price to USD 0.5060/lb, the textile mill will now have to pay USD 2,530,000 for the 5.00 million pounds of cotton. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the cotton futures price will have converged with the cotton spot price and will be equal to USD 0.5060/lb. As the long futures position was entered at a lower price of USD 0.4600/lb, it will have gained USD 0.5060 – USD 0.4600 = USD 0.0460 per pound. With 100 contracts covering a total of 5.00 million pounds of cotton, the total gain from the long futures position is USD 230,000.

In the end, the higher purchase price is offset by the gain in the cotton futures market, resulting in a net payment amount of USD 2,530,000 – USD 230,000 = USD 2,300,000. This amount is equivalent to the amount payable when buying the 5.00 million pounds of cotton at USD 0.4600/lb.

Scenario #2: Cotton Spot Price Fell by 10% to USD 0.4140/lb on Delivery Date

With the spot price having fallen to USD 0.4140/lb, the textile mill will only need to pay USD 2,070,000 for the cotton. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the cotton futures price will have converged with the cotton spot price and will be equal to USD 0.4140/lb. As the long futures position was entered at USD 0.4600/lb, it will have lost USD 0.4600 – USD 0.4140 = USD 0.0460 per pound. With 100 contracts covering a total of 5.00 million pounds, the total loss from the long futures position is USD 230,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the cotton futures market and the net amount payable will be USD 2,070,000 + USD 230,000 = USD 2,300,000. Once again, this amount is equivalent to buying 5.00 million pounds of cotton at USD 0.4600/lb.

Risk/Reward Tradeoff

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

Learn More About Cotton Futures & Options Trading

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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. ]

How Are Futures Used to Hedge a Position?

Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price. The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price.

The ultimate goal of an investor using futures contracts to hedge is to perfectly offset their risk. In real life, however, this can be impossible. Therefore, individuals attempt to neutralize risk as much as possible instead. Here, we dig a little bit deeper into using futures to hedge.

Key Takeaways

  • Futures contracts allow producers, consumer, and investors to hedge certain market risks.
  • For instance, a farmer planting wheat today may sell a wheat futures contract now. He will then buy it back come harvest when he sells his wheat – effectively locking in today’s price and hedging away market fluctuations between planting and harvest.
  • Because futures contracts often require actual delivery of the underlying at expiration, hedgers must be sure to exit or roll over positions before expiry.

Using Futures Contracts to Hedge

When a company knows that it will be making a purchase in the future for a particular item, it should take a long position in a futures contract to hedge its position. For example, suppose that Company X knows that in six months it will have to buy 20,000 ounces of silver to fulfill an order. Assume the spot price for silver is $12/ounce and the six-month futures price is $11/ounce. By buying the futures contract, Company X can lock in a price of $11/ounce. This reduces the company’s risk because it will be able to close its futures position and buy 20,000 ounces of silver for $11/ounce in six months.

If a company knows that it will be selling a certain item, it should take a short position in a futures contract to hedge its position. As an example, Company X must fulfill a contract in six months that requires it to sell 20,000 ounces of silver. Assume the spot price for silver is $12/ounce and the futures price is $11/ounce. Company X would short futures contracts on silver and close out the futures position in six months. In this case, the company has reduced its risk by ensuring that it will receive $11 for each ounce of silver it sells.

Futures contracts can be very useful in limiting the risk exposure that an investor has in a trade. The main advantage of participating in a futures contract is that it removes the uncertainty about the future price of an item. By locking in a price for which you are able to buy or sell a particular item, companies are able to eliminate the ambiguity having to do with expected expenses and profits.

Sometimes, if a commodity to be hedged is not available as a futures contract, an investor will instead seek out a futures contract in something that closely follows the movements of that commodity, for example buying wheat futures to hedge the production of barley.

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