Businesses that need to buy significant quantities of platinum can hedge against rising platinum price by taking up a position in the platinum futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of platinum that they will require sometime in the future.
To implement the long hedge, enough platinum futures are to be purchased to cover the quantity of platinum required by the business operator.
An automaker will need to procure 5,000 troy ounces of platinum in 3 months' time. The prevailing spot price for platinum is USD 964.00/oz while the price of platinum futures for delivery in 3 months' time is USD 960.00/oz. To hedge against a rise in platinum price, the automaker decided to lock in a future purchase price of USD 960.00/oz by taking a long position in an appropriate number of NYMEX Platinum futures contracts. With each NYMEX Platinum futures contract covering 50 troy ounces of platinum, the automaker 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 automaker will be able to purchase the 5,000 troy ounces of platinum at USD 960.00/oz for a total amount of USD 4,800,000. Let's see how this is achieved by looking at scenarios in which the price of platinum makes a significant move either upwards or downwards by delivery date.
With the increase in platinum price to USD 1,060/oz, the automaker will now have to pay USD 5,302,000 for the 5,000 troy ounces of platinum. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the platinum futures price will have converged with the platinum spot price and will be equal to USD 1,060/oz. As the long futures position was entered at a lower price of USD 960.00/oz, it will have gained USD 1,060 - USD 960.00 = USD 100.40 per troy ounce. With 100 contracts covering a total of 5,000 troy ounces of platinum, the total gain from the long futures position is USD 502,000.
In the end, the higher purchase price is offset by the gain in the platinum futures market, resulting in a net payment amount of USD 5,302,000 - USD 502,000 = USD 4,800,000. This amount is equivalent to the amount payable when buying the 5,000 troy ounces of platinum at USD 960.00/oz.
With the spot price having fallen to USD 867.60/oz, the automaker will only need to pay USD 4,338,000 for the platinum. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the platinum futures price will have converged with the platinum spot price and will be equal to USD 867.60/oz. As the long futures position was entered at USD 960.00/oz, it will have lost USD 960.00 - USD 867.60 = USD 92.40 per troy ounce. With 100 contracts covering a total of 5,000 troy ounces, the total loss from the long futures position is USD 462,000
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the platinum futures market and the net amount payable will be USD 4,338,000 + USD 462,000 = USD 4,800,000. Once again, this amount is equivalent to buying 5,000 troy ounces of platinum at USD 960.00/oz.
As you can see from the above examples, the downside of the long hedge is that the platinum buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising platinum prices while still be able to benefit from a fall in platinum price is to buy platinum call options.
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