The following explanation and illustrations are an excerpt from CMEGroup’s publication, “Self-Study Guide to Hedging with Grain and Oilseed Futures and Options”. As an educational supplement, watch an example using a simple online hedge calculator in our newsletter. Take a quiz to help further your knowledge.
Comparing Commodity Purchasing Strategies
A commodity buyer should realize that there isn’t one “perfect” strategy for all firms or for all market conditions. Different economic conditions require different purchasing strategies. Therefore, an astute commodity buyer should become familiar with all of the available purchasing strategies. They should learn how to evaluate and compare the strategies, and sometimes realize that a strategy may need to be revised, even in the middle of a purchasing cycle, due to changing market conditions.
The purchasing strategies we looked at in this chapter are some of the more common ones, but by no means, are they to be considered a complete list of purchasing strategies. Each firm with their own risk/reward profiles will have to make a decision – which strategy is the best for their needs.
The following chart compares four purchasing strategies involving futures or options and one strategy without price risk management. Each of the strategies has strengths and weaknesses, which will be discussed in the following paragraphs.
Note: All of the following strategies being compared assume a basis of 10 cents under the Dec Wheat futures contract. If the basis turns out to be anything other than 10 cents under the December contract, the effective purchase price will be different. A stronger basis would increase the purchase price and a weaker than expected basis would lower the effective purchase price.
Long Futures
The long futures position is the most basic price risk management strategy for a commodity buyer. This strategy allows the commodity buyer to “lock in a price level” in advance of the actual purchase. It provides protection against the risk of rising prices but does not allow improvement in the purchase price should the market decline. This position requires the payment of a broker’s commission as well as the costs associated with maintaining a performance bond/margin account. In the following table, the long futures position fares the best when the market moves higher (i.e., when the price risk occurs).
Long Call Option
The long call option position provides protection against rising commodity prices but also allows the buyer to improve on the purchase price if the market declines. The long call position “establishes a maximum (ceiling) price level.” The protection and opportunity of a long call option position comes at a cost – the call option buyer must pay the option premium at the time of the purchase. In the table, the long call option provides upside price protection similar to the long futures position except at a cost. Unlike the long futures position, the long call option nets a better purchase price when the market declines. The long call option does not require performance bond/margin.
Short Put Option
Although the short put option position is the riskiest of the strategies that we covered in this publication, it provides the best purchase price in a stable market, as seen in the table. However, if the market declines, the put option “establishes a minimum (floor) purchase price level.” The worst case scenario for this strategy is if the market rallies because the upside protection is limited to the premium collected for selling the put. The short put strategy requires performance bond/margin.
Long Call Option and Short Put Option
By combining the short put position with the long call position, the commodity buyer establishes a lower ceiling price level because of the premium received for selling the put. However, the cost of this benefit is that the short put position limits the opportunity of lower prices by establishing a floor price level. Effectively, the commodity buyer “established a purchase price range” with this strategy. The price range is determined by the strike prices and therefore can be adjusted (widened or narrowed) by choosing alternative strike prices. After the long futures position, this strategy provided the most protection against rising prices, as noted in the table.
Do Nothing
Doing nothing to manage purchasing price risk is the most simplistic strategy for a commodity buyer – but also the most dangerous should the market rally. Doing nothing will yield the best purchase price as the market declines but “provides zero risk management” against a rising market, as indicated in the table.
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Other Purchasing Strategies
There are many other purchasing strategies available to a commodity buyer. These strategies may involve futures, options or cash market positions and each will have their own set of advantages and disadvantages. As stated earlier in this chapter, a good commodity buyer should acquaint themselves with all of their alternatives and understand when a specific strategy should be employed or revised. Remember, a strategy that worked effectively for one commodity purchase may not be the best for your next commodity purchase.
If you're a commodity risk manager looking for assistance on hedging, please visit our partner site OahuCapital.com for active assistance.