Hedging Against Rising Ethanol Prices using Ethanol Futures

Businesses that need to buy significant quantities of ethanol can hedge against rising ethanol price by taking up a position in the ethanol futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of ethanol that they will require sometime in the future.

To implement the long hedge, enough ethanol futures are to be purchased to cover the quantity of ethanol required by the business operator.

Ethanol Futures Long Hedge Example

A motor fuel distributor will need to procure 2.90 million gallons of ethanol in 3 months' time. The prevailing spot price for ethanol is USD 1.5800/gal while the price of ethanol futures for delivery in 3 months' time is USD 1.6000/gal. To hedge against a rise in ethanol price, the motor fuel distributor decided to lock in a future purchase price of USD 1.6000/gal by taking a long position in an appropriate number of CBOT Ethanol futures contracts. With each CBOT Ethanol futures contract covering 29000 gallons of ethanol, the motor fuel distributor 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 motor fuel distributor will be able to purchase the 2.90 million gallons of ethanol at USD 1.6000/gal for a total amount of USD 4,640,000. Let's see how this is achieved by looking at scenarios in which the price of ethanol makes a significant move either upwards or downwards by delivery date.

0.00% Commissions Option Trading!
Trade options FREE For 60 Days when you Open a New OptionsHouse Account

Scenario #1: Ethanol Spot Price Rose by 10% to USD 1.7380/gal on Delivery Date

With the increase in ethanol price to USD 1.7380/gal, the motor fuel distributor will now have to pay USD 5,040,200 for the 2.90 million gallons of ethanol. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the ethanol futures price will have converged with the ethanol spot price and will be equal to USD 1.7380/gal. As the long futures position was entered at a lower price of USD 1.6000/gal, it will have gained USD 1.7380 - USD 1.6000 = USD 0.1380 per gallon. With 100 contracts covering a total of 2.90 million gallons of ethanol, the total gain from the long futures position is USD 400,200.

In the end, the higher purchase price is offset by the gain in the ethanol futures market, resulting in a net payment amount of USD 5,040,200 - USD 400,200 = USD 4,640,000. This amount is equivalent to the amount payable when buying the 2.90 million gallons of ethanol at USD 1.6000/gal.

Scenario #2: Ethanol Spot Price Fell by 10% to USD 1.4220/gal on Delivery Date

With the spot price having fallen to USD 1.4220/gal, the motor fuel distributor will only need to pay USD 4,123,800 for the ethanol. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the ethanol futures price will have converged with the ethanol spot price and will be equal to USD 1.4220/gal. As the long futures position was entered at USD 1.6000/gal, it will have lost USD 1.6000 - USD 1.4220 = USD 0.1780 per gallon. With 100 contracts covering a total of 2.90 million gallons, the total loss from the long futures position is USD 516,200

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the ethanol futures market and the net amount payable will be USD 4,123,800 + USD 516,200 = USD 4,640,000. Once again, this amount is equivalent to buying 2.90 million gallons of ethanol at USD 1.6000/gal.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the ethanol buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising ethanol prices while still be able to benefit from a fall in ethanol price is to buy ethanol call options.

Learn More About Ethanol Futures & Options Trading

Continue Reading...

Buying Straddles into Earnings

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...]

Writing Puts to Purchase Stocks

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...]

What are Binary Options and How to Trade Them?

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...]

Investing in Growth Stocks using LEAPSÂ® options

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...]

Effect of Dividends on Option Pricing

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...]

Bull Call Spread: An Alternative to the Covered Call

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...]

Dividend Capture using Covered Calls

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...]

Leverage using Calls, Not Margin Calls

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 using Options

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...]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator.... [Read on...]

Understanding Put-Call Parity

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...]

Understanding the Greeks

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...]

Valuing Common Stock using Discounted Cash Flow Analysis

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...]

Follow Us on Facebook to Get Daily Strategies & Tips!

The Options Guide