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.
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.
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.
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.
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.
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