Businesses that need to buy significant quantities of rice can hedge against rising rice price by taking up a position in the rice futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of rice that they will require sometime in the future.
To implement the long hedge, enough rice futures are to be purchased to cover the quantity of rice required by the business operator.
A rice exporter will need to procure 200,000 hundredweights of rice in 3 months' time. The prevailing spot price for rice is USD 13.71/cwt while the price of rice futures for delivery in 3 months' time is USD 14.00/cwt. To hedge against a rise in rice price, the rice exporter decided to lock in a future purchase price of USD 14.00/cwt by taking a long position in an appropriate number of CBOT Rough Rice futures contracts. With each CBOT Rough Rice futures contract covering 2000 hundredweights of rice, the rice exporter 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 rice exporter will be able to purchase the 200,000 hundredweights of rice at USD 14.00/cwt for a total amount of USD 2,800,000. Let's see how this is achieved by looking at scenarios in which the price of rice makes a significant move either upwards or downwards by delivery date.
With the increase in rice price to USD 15.08/cwt, the rice exporter will now have to pay USD 3,016,200 for the 200,000 hundredweights of rice. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the rice futures price will have converged with the rice spot price and will be equal to USD 15.08/cwt. As the long futures position was entered at a lower price of USD 14.00/cwt, it will have gained USD 15.08 - USD 14.00 = USD 1.0810 per hundredweight. With 100 contracts covering a total of 200,000 hundredweights of rice, the total gain from the long futures position is USD 216,200.
In the end, the higher purchase price is offset by the gain in the rice futures market, resulting in a net payment amount of USD 3,016,200 - USD 216,200 = USD 2,800,000. This amount is equivalent to the amount payable when buying the 200,000 hundredweights of rice at USD 14.00/cwt.
With the spot price having fallen to USD 12.34/cwt, the rice exporter will only need to pay USD 2,467,800 for the rice. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the rice futures price will have converged with the rice spot price and will be equal to USD 12.34/cwt. As the long futures position was entered at USD 14.00/cwt, it will have lost USD 14.00 - USD 12.34 = USD 1.6610 per hundredweight. With 100 contracts covering a total of 200,000 hundredweights, the total loss from the long futures position is USD 332,200
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the rice futures market and the net amount payable will be USD 2,467,800 + USD 332,200 = USD 2,800,000. Once again, this amount is equivalent to buying 200,000 hundredweights of rice at USD 14.00/cwt.
As you can see from the above examples, the downside of the long hedge is that the rice buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising rice prices while still be able to benefit from a fall in rice price is to buy rice 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!
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...]
Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time.....[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 LEAPSÂ® and why I consider them to be a great option for investing in the next MicrosoftÂ®.... [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...]
Risk Warning: Stocks, futures and binary options trading discussed on this website can be considered High-Risk Trading Operations and their execution can be very risky and may result in significant losses or even in a total loss of all funds on your account. You should not risk more than you afford to lose. Before deciding to trade, you need to ensure that you understand the risks involved taking into account your investment objectives and level of experience. Information on this website is provided strictly for informational and educational purposes only and is not intended as a trading recommendation service. TheOptionsGuide.com shall not be liable for any errors, omissions, or delays in the content, or for any actions taken in reliance thereon.