Businesses that need to buy significant quantities of oats can hedge against rising oats price by taking up a position in the oats futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of oats that they will require sometime in the future.
To implement the long hedge, enough oats futures are to be purchased to cover the quantity of oats required by the business operator.
An oats mill will need to procure 500,000 bushels of oats in 3 months' time. The prevailing spot price for oats is USD 2.0900/bu while the price of oats futures for delivery in 3 months' time is USD 2.1000/bu. To hedge against a rise in oats price, the oats mill decided to lock in a future purchase price of USD 2.1000/bu by taking a long position in an appropriate number of CBOT Oats futures contracts. With each CBOT Oats futures contract covering 5000 bushels of oats, the oats 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 oats mill will be able to purchase the 500,000 bushels of oats at USD 2.1000/bu for a total amount of USD 1,050,000. Let's see how this is achieved by looking at scenarios in which the price of oats makes a significant move either upwards or downwards by delivery date.
With the increase in oats price to USD 2.2990/bu, the oats mill will now have to pay USD 1,149,500 for the 500,000 bushels of oats. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the oats futures price will have converged with the oats spot price and will be equal to USD 2.2990/bu. As the long futures position was entered at a lower price of USD 2.1000/bu, it will have gained USD 2.2990 - USD 2.1000 = USD 0.1990 per bushel. With 100 contracts covering a total of 500,000 bushels of oats, the total gain from the long futures position is USD 99,500.
In the end, the higher purchase price is offset by the gain in the oats futures market, resulting in a net payment amount of USD 1,149,500 - USD 99,500 = USD 1,050,000. This amount is equivalent to the amount payable when buying the 500,000 bushels of oats at USD 2.1000/bu.
With the spot price having fallen to USD 1.8810/bu, the oats mill will only need to pay USD 940,500 for the oats. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the oats futures price will have converged with the oats spot price and will be equal to USD 1.8810/bu. As the long futures position was entered at USD 2.1000/bu, it will have lost USD 2.1000 - USD 1.8810 = USD 0.2190 per bushel. With 100 contracts covering a total of 500,000 bushels, the total loss from the long futures position is USD 109,500
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the oats futures market and the net amount payable will be USD 940,500 + USD 109,500 = USD 1,050,000. Once again, this amount is equivalent to buying 500,000 bushels of oats at USD 2.1000/bu.
As you can see from the above examples, the downside of the long hedge is that the oats buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising oats prices while still be able to benefit from a fall in oats price is to buy oats call options.
To buy or sell futures, you need a broker that can handle futures trades.
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