Hedging is one of the best ways for businesses to protect themselves against fluctuations in commodity prices. Commodity options have been used by businesses for times immemorial to insure them against major price swings long before they were picked up by general investors. Let’s explore some of the reasons why hedging is a key part of financial stability in business today.
Protection from Price Swings for Sellers
Let’s take the example of a farmer expecting to sell a crop at price X. If the farmer buys options at 0.8 X, he’s protected himself from a price drop. If the crop sells at X, the farmer can pay a modest premium to the buyer of the futures at 0.8X and sell the crop at price X. If the farmer buys options for price 1 2X, 20% more than the expected price, the farmer can sell the crop at 120% the price of X and pay the futures contract holder the basis over price X or sell the crop at 1 2X. In this way, commodity sellers can use futures to generate money, whether the product’s sale price is much higher or lower than expected. They can use commodity options to make even more money from such price swings for less money than a percentage of the value of what they are selling.
How do commodity options help you in other cases? A buying hedge strategy is often used to protect the uncovered forward sale of finished products or replace inventory at a lower cost than what the market currently dictates.
Price Protection for Buyers
Commodity futures offer price protection for buyers. Locking in the price of a commodity allows businesses to know what they’ll have to pay in the future. Airlines often buy commodity futures to lock in the price of fuel against potential price spikes due to a foreign war or disrupted supply chain. If you’re after quick stability, these products can be used to hedge financial risk. Commodity options are a low-cost way to hedge one’s bets in the opposite direction.
For example, a business can buy a futures contract to lock in the price they’ll pay for essential supplies while entering commodity options contracts for very high and low prices in case they were very far off on their price projections. The strategic use of commodity options is thus a risk management tool, transferring price risk to the market.
Securing Items on the Spot Market without the Price Shock
The spot market refers to the market of products and commodities that are available right now. The spot market for electricity is the price you pay for excess power generation when all other capacity is spoken for. Spot market pricing for power may be four times or even more the standard price you pay per kilowatt. Short hedgers buy commodities on the spot market and sell similar amounts on the futures market. This strategy may allow utilities to secure power today while offsetting the high cost against promised capacity tomorrow. This same strategy is open to businesses who need to secure products and raw materials when demand is peaking, offsetting the price they pay by promising to supply someone else’s future need.
Commodity futures contracts allow you to lock in a price for an item you want to buy or sell. Commodity options allow you to hedge your price bet by covering both the risk of higher and lower prices when the futures contract comes due. It costs you a small percentage of the price swing, but minimises the financial risk of being wiped out by prices too high or low. You can use commodity options to raise cash now to offset the high price you pay on the spot market.