Pork Bellies producers can hedge against falling pork bellies price by taking up a position in the pork bellies futures market.
Pork Bellies producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of pork bellies that is only ready for sale sometime in the future.
To implement the short hedge, pork bellies producers sell (short) enough pork bellies futures contracts in the futures market to cover the quantity of pork bellies to be produced.
A pork bellies producer has just entered into a contract to sell 4.00 million pounds of pork bellies, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of pork bellies on the day of delivery. At the time of signing the agreement, spot price for pork bellies is USD 0.8470/lb while the price of pork bellies futures for delivery in 3 months' time is USD 0.8500/lb.
To lock in the selling price at USD 0.8500/lb, the pork bellies producer can enter a short position in an appropriate number of CME Frozen Pork Bellies futures contracts. With each CME Frozen Pork Bellies futures contract covering 40,000 pounds of pork bellies, the pork bellies producer will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the pork bellies producer will be able to sell the 4.00 million pounds of pork bellies at USD 0.8500/lb for a total amount of USD 3,400,000. Let's see how this is achieved by looking at scenarios in which the price of pork bellies makes a significant move either upwards or downwards by delivery date.
As per the sales contract, the pork bellies producer will have to sell the pork bellies at only USD 0.7623/lb, resulting in a net sales proceeds of USD 3,049,200.
By delivery date, the pork bellies futures price will have converged with the pork bellies spot price and will be equal to USD 0.7623/lb. As the short futures position was entered at USD 0.8500/lb, it will have gained USD 0.8500 - USD 0.7623 = USD 0.0877 per pound. With 100 contracts covering a total of 4000000 pounds, the total gain from the short futures position is USD 350,800
Together, the gain in the pork bellies futures market and the amount realised from the sales contract will total USD 350,800 + USD 3,049,200 = USD 3,400,000. This amount is equivalent to selling 4.00 million pounds of pork bellies at USD 0.8500/lb.
With the increase in pork bellies price to USD 0.9317/lb, the pork bellies producer will be able to sell the 4.00 million pounds of pork bellies for a higher net sales proceeds of USD 3,726,800.
However, as the short futures position was entered at a lower price of USD 0.8500/lb, it will have lost USD 0.9317 - USD 0.8500 = USD 0.0817 per pound. With 100 contracts covering a total of 4.00 million pounds of pork bellies, the total loss from the short futures position is USD 326,800.
In the end, the higher sales proceeds is offset by the loss in the pork bellies futures market, resulting in a net proceeds of USD 3,726,800 - USD 326,800 = USD 3,400,000. Again, this is the same amount that would be received by selling 4.00 million pounds of pork bellies at USD 0.8500/lb.
As can be seen from the above examples, the downside of the short hedge is that the pork bellies seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling pork bellies prices while still be able to benefit from a rise in pork bellies price is to buy pork bellies 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!