Oats producers can hedge against falling oats price by taking up a position in the oats futures market.
Oats producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of oats that is only ready for sale sometime in the future.
To implement the short hedge, oats producers sell (short) enough oats futures contracts in the futures market to cover the quantity of oats to be produced.
An oats farmer has just entered into a contract to sell 500,000 bushels of oats, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of oats on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 2.1000/bu, the oats farmer can enter a short position in an appropriate number of CBOT Oats futures contracts. With each CBOT Oats futures contract covering 5,000 bushels of oats, the oats farmer will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the oats farmer will be able to sell 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.
As per the sales contract, the oats farmer will have to sell the oats at only USD 1.8810/bu, resulting in a net sales proceeds of USD 940,500.
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 short futures position was entered at USD 2.1000/bu, it will have gained USD 2.1000 - USD 1.8810 = USD 0.2190 per bushel. With 100 contracts covering a total of 500000 bushels, the total gain from the short futures position is USD 109,500
Together, the gain in the oats futures market and the amount realised from the sales contract will total USD 109,500 + USD 940,500 = USD 1,050,000. This amount is equivalent to selling 500,000 bushels of oats at USD 2.1000/bu.
With the increase in oats price to USD 2.2990/bu, the oats producer will be able to sell the 500,000 bushels of oats for a higher net sales proceeds of USD 1,149,500.
However, as the short futures position was entered at a lower price of USD 2.1000/bu, it will have lost 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 loss from the short futures position is USD 99,500.
In the end, the higher sales proceeds is offset by the loss in the oats futures market, resulting in a net proceeds of USD 1,149,500 - USD 99,500 = USD 1,050,000. Again, this is the same amount that would be received by selling 500,000 bushels of oats at USD 2.1000/bu.
As can be seen from the above examples, the downside of the short hedge is that the oats seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling oats prices while still be able to benefit from a rise in oats price is to buy oats put 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!
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...]
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...]
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...]
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...]
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...]
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...]
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 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...]
Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator.... [Read on...]
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...]
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...]
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...]