Businesses that need to buy significant quantities of nickel can hedge against rising nickel price by taking up a position in the nickel futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of nickel that they will require sometime in the future.
To implement the long hedge, enough nickel futures are to be purchased to cover the quantity of nickel required by the business operator.
A steel manufacturer will need to procure 600 tonnes of nickel in 3 months' time. The prevailing spot price for nickel is USD 10,100/ton while the price of nickel futures for delivery in 3 months' time is USD 10,000/ton. To hedge against a rise in nickel price, the steel manufacturer decided to lock in a future purchase price of USD 10,000/ton by taking a long position in an appropriate number of LME Nickel futures contracts. With each LME Nickel futures contract covering 6 tonnes of nickel, the steel manufacturer 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 steel manufacturer will be able to purchase the 600 tonnes of nickel at USD 10,000/ton for a total amount of USD 6,000,000. Let's see how this is achieved by looking at scenarios in which the price of nickel makes a significant move either upwards or downwards by delivery date.
With the increase in nickel price to USD 11,110/ton, the steel manufacturer will now have to pay USD 6,666,000 for the 600 tonnes of nickel. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the nickel futures price will have converged with the nickel spot price and will be equal to USD 11,110/ton. As the long futures position was entered at a lower price of USD 10,000/ton, it will have gained USD 11,110 - USD 10,000 = USD 1,110 per tonne. With 100 contracts covering a total of 600 tonnes of nickel, the total gain from the long futures position is USD 666,000.
In the end, the higher purchase price is offset by the gain in the nickel futures market, resulting in a net payment amount of USD 6,666,000 - USD 666,000 = USD 6,000,000. This amount is equivalent to the amount payable when buying the 600 tonnes of nickel at USD 10,000/ton.
With the spot price having fallen to USD 9,090/ton, the steel manufacturer will only need to pay USD 5,454,000 for the nickel. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the nickel futures price will have converged with the nickel spot price and will be equal to USD 9,090/ton. As the long futures position was entered at USD 10,000/ton, it will have lost USD 10,000 - USD 9,090 = USD 910.00 per tonne. With 100 contracts covering a total of 600 tonnes, the total loss from the long futures position is USD 546,000
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the nickel futures market and the net amount payable will be USD 5,454,000 + USD 546,000 = USD 6,000,000. Once again, this amount is equivalent to buying 600 tonnes of nickel at USD 10,000/ton.
As you can see from the above examples, the downside of the long hedge is that the nickel buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising nickel prices while still be able to benefit from a fall in nickel price is to buy nickel call options.
To buy or sell futures, you need a broker that can handle futures trades.
OptionsHouse is a full fledged Futures Commission Merchant that provides a streamlined access to the futures markets at extremely reasonable contract rates.Click here to open a futures trading account at OptionsHouse.com now!