Hedging Against Falling Copper Prices using Copper Futures

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Contents

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.

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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.

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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. ]

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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. ]

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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 Falling Copper Prices using Copper Futures

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

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

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

Copper Futures Short Hedge Example

A copper mining company has just entered into a contract to sell 2,500 tonnes of copper, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of copper on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 3,200/ton, the copper mining company can enter a short 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 mining company will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the copper mining company will be able to sell 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 Fell by 10% to USD 2,854/ton on Delivery Date

As per the sales contract, the copper mining company will have to sell the copper at only USD 2,854/ton, resulting in a net sales proceeds of USD 7,134,750.

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 short futures position was entered at USD 3,200/ton, it will have gained USD 3,200 – USD 2,854 = USD 346.10 per tonne. With 100 contracts covering a total of 2500 tonnes, the total gain from the short futures position is USD 865,250

Together, the gain in the copper futures market and the amount realised from the sales contract will total USD 865,250 + USD 7,134,750 = USD 8,000,000. This amount is equivalent to selling 2,500 tonnes of copper at USD 3,200/ton.

Scenario #2: 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 producer will be able to sell the 2,500 tonnes of copper for a higher net sales proceeds of USD 8,720,250.

However, as the short futures position was entered at a lower price of USD 3,200/ton, it will have lost 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 loss from the short futures position is USD 720,250.

In the end, the higher sales proceeds is offset by the loss in the copper futures market, resulting in a net proceeds of USD 8,720,250 – USD 720,250 = USD 8,000,000. Again, this is the same amount that would be received by selling 2,500 tonnes of copper at USD 3,200/ton.

Risk/Reward Tradeoff

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

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

Learn More About Copper Futures & Options Trading

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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. ]

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