Hedging Against Rising Silver Prices using Silver Futures

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Contents

Hedging Against Rising Silver Prices using Silver Futures

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

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

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

Silver Futures Long Hedge Example

A silverware company will need to procure 3.00 million grams of silver in 3 months’ time. The prevailing spot price for silver is JPY 30.23/gm while the price of silver futures for delivery in 3 months’ time is JPY 30.00/gm. To hedge against a rise in silver price, the silverware company decided to lock in a future purchase price of JPY 30.00/gm by taking a long position in an appropriate number of TOCOM Silver futures contracts. With each TOCOM Silver futures contract covering 30000 grams of silver, the silverware company 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 silverware company will be able to purchase the 3.00 million grams of silver at JPY 30.00/gm for a total amount of JPY 90,000,000. Let’s see how this is achieved by looking at scenarios in which the price of silver makes a significant move either upwards or downwards by delivery date.

Scenario #1: Silver Spot Price Rose by 10% to JPY 33.25/gm on Delivery Date

With the increase in silver price to JPY 33.25/gm, the silverware company will now have to pay JPY 99,759,000 for the 3.00 million grams of silver. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the silver futures price will have converged with the silver spot price and will be equal to JPY 33.25/gm. As the long futures position was entered at a lower price of JPY 30.00/gm, it will have gained JPY 33.25 – JPY 30.00 = JPY 3.2530 per gram. With 100 contracts covering a total of 3.00 million grams of silver, the total gain from the long futures position is JPY 9,759,000.

In the end, the higher purchase price is offset by the gain in the silver futures market, resulting in a net payment amount of JPY 99,759,000 – JPY 9,759,000 = JPY 90,000,000. This amount is equivalent to the amount payable when buying the 3.00 million grams of silver at JPY 30.00/gm.

Scenario #2: Silver Spot Price Fell by 10% to JPY 27.21/gm on Delivery Date

With the spot price having fallen to JPY 27.21/gm, the silverware company will only need to pay JPY 81,621,000 for the silver. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the silver futures price will have converged with the silver spot price and will be equal to JPY 27.21/gm. As the long futures position was entered at JPY 30.00/gm, it will have lost JPY 30.00 – JPY 27.21 = JPY 2.7930 per gram. With 100 contracts covering a total of 3.00 million grams, the total loss from the long futures position is JPY 8,379,000

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Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the silver futures market and the net amount payable will be JPY 81,621,000 + JPY 8,379,000 = JPY 90,000,000. Once again, this amount is equivalent to buying 3.00 million grams of silver at JPY 30.00/gm.

Risk/Reward Tradeoff

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

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

Learn More About Silver Futures & Options Trading

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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.

Hedging Against Falling Silver Prices using Silver Futures

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

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

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

Silver Futures Short Hedge Example

A silver mining firm has just entered into a contract to sell 3.00 million grams of silver, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of silver on the day of delivery. At the time of signing the agreement, spot price for silver is JPY 30.23/gm while the price of silver futures for delivery in 3 months’ time is JPY 30.00/gm.

To lock in the selling price at JPY 30.00/gm, the silver mining firm can enter a short position in an appropriate number of TOCOM Silver futures contracts. With each TOCOM Silver futures contract covering 30,000 grams of silver, the silver mining firm will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the silver mining firm will be able to sell the 3.00 million grams of silver at JPY 30.00/gm for a total amount of JPY 90,000,000. Let’s see how this is achieved by looking at scenarios in which the price of silver makes a significant move either upwards or downwards by delivery date.

Scenario #1: Silver Spot Price Fell by 10% to JPY 27.21/gm on Delivery Date

As per the sales contract, the silver mining firm will have to sell the silver at only JPY 27.21/gm, resulting in a net sales proceeds of JPY 81,621,000.

By delivery date, the silver futures price will have converged with the silver spot price and will be equal to JPY 27.21/gm. As the short futures position was entered at JPY 30.00/gm, it will have gained JPY 30.00 – JPY 27.21 = JPY 2.7930 per gram. With 100 contracts covering a total of 3000000 grams, the total gain from the short futures position is JPY 8,379,000

Together, the gain in the silver futures market and the amount realised from the sales contract will total JPY 8,379,000 + JPY 81,621,000 = JPY 90,000,000. This amount is equivalent to selling 3.00 million grams of silver at JPY 30.00/gm.

Scenario #2: Silver Spot Price Rose by 10% to JPY 33.25/gm on Delivery Date

With the increase in silver price to JPY 33.25/gm, the silver producer will be able to sell the 3.00 million grams of silver for a higher net sales proceeds of JPY 99,759,000.

However, as the short futures position was entered at a lower price of JPY 30.00/gm, it will have lost JPY 33.25 – JPY 30.00 = JPY 3.2530 per gram. With 100 contracts covering a total of 3.00 million grams of silver, the total loss from the short futures position is JPY 9,759,000.

In the end, the higher sales proceeds is offset by the loss in the silver futures market, resulting in a net proceeds of JPY 99,759,000 – JPY 9,759,000 = JPY 90,000,000. Again, this is the same amount that would be received by selling 3.00 million grams of silver at JPY 30.00/gm.

Risk/Reward Tradeoff

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

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

Learn More About Silver 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?

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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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    Best For Beginners!
    Free Trading Education!
    Free Demo Account!
    Get Your Sign-Up Bonus Now:

  • BINOMO
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    Only For Experienced Traders.

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