If you produce, consume or speculate on commodity prices, you probably use futures contracts to control risk or make a profit. Physically settled futures obligate buyers to take delivery of a specified amount of the commodity at a preset price and time. Many futures are cash-settled: No commodity is delivered; the contract is simply a price bet. Options give you the ability to hedge your futures contracts, thereby reducing risk.
Hedging and Futures
Futures are themselves hedging instruments for commodity suppliers and consumers. For example, if you grow wheat, you can lock in a price at planting time that will determine your sales revenue at harvest. You do this by selling one or more futures contracts for wheat. The contract protects you from falling prices, but you surrender the chance of additional profits on rising prices.
Hedging the Hedge
A wheat farmer may not be completely satisfied with the prospect of losing additional profit if wheat prices rise, especially if he foresees a drought. The solution is a call option on the wheat contract. Each call option gives the buyer the right to purchase a futures contract with the matching expiration date and strike price -- the futures price of the commodity. For a relatively modest bet, the wheat farmer can profit if wheat prices exceed the strike price by expiration of the contracts. If wheat prices fall, the farmer loses only the price of the call option. The futures contract protects him from further losses.
Speculators Can Hedge Too
The wheat farmer’s niece may want to participate in the price action of wheat even though she's never seen a farm. She agrees with her uncle that prices will rise and buys five wheat contracts. Of course, she doesn’t want to buy 25,000 bushels of wheat, so she'll sell the contracts before expiration. She also doesn’t want to take a loss. She can buy five puts on the futures contracts, giving her the right to sell five wheat futures contracts at the strike price. If prices fall, the puts will gain value to offset part of her loss on the futures. If prices rise, the niece can net a profit if the futures contracts' gain from the higher prices exceeds the cost of the puts. The most she can lose is the price of five put contracts.
You can use your futures brokerage account to purchase options. If you want to protect yourself from falling prices, you buy put options. Call options protect you from higher prices. Each call lets you buy a futures contract at the strike price, while puts allow you to sell futures contracts at the strike price. Standard practice is to buy options with the same expiration date as that of the futures contracts. If your futures and options share the same strike price, you are fully hedged. You can partially hedge by buying fewer options or purchasing options with strike prices further away from the futures price.
Say the farmer sells one 5,000-bushel September futures contract priced at $7.30 per bushel, or $36,500. He must deposit $3,240 in his brokerage account as collateral for the contract. This is the “initial margin.” At the same time, he buys one 5,000 bushel September call option with a $7.30 strike for 44 cents per bushel, or $2,200, which he must pay up front. Fast forward to September. The farmer delivers his wheat and realizes $36,500 from the futures contract. If the price per bushel is $7.30 or lower, he is out the price of the call. For every quarter-cent above $7.30 per bushel, the farmer earns an additional $12.50 per option contract. In this case, a drought causes wheat to climb to $8.50 per bushel, so the farmer’s call is worth $6,000, a $3,800 profit. His hedge has partially offset the profit he lost by locking in the $7.30 price.
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