Hedging Against Rising Wheat Prices using Wheat Futures

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Contents

Hedging Against Rising Wheat Prices using Wheat Futures

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

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

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

Wheat Futures Long Hedge Example

A bread maker will need to procure 500,000 bushels of wheat in 3 months’ time. The prevailing spot price for wheat is USD 5.7000/bu while the price of wheat futures for delivery in 3 months’ time is USD 5.7000/bu. To hedge against a rise in wheat price, the bread maker decided to lock in a future purchase price of USD 5.7000/bu by taking a long position in an appropriate number of CBOT Wheat futures contracts. With each CBOT Wheat futures contract covering 5000 bushels of wheat, the bread maker 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 bread maker will be able to purchase the 500,000 bushels of wheat at USD 5.7000/bu for a total amount of USD 2,850,000. Let’s see how this is achieved by looking at scenarios in which the price of wheat makes a significant move either upwards or downwards by delivery date.

Scenario #1: Wheat Spot Price Rose by 10% to USD 6.2700/bu on Delivery Date

With the increase in wheat price to USD 6.2700/bu, the bread maker will now have to pay USD 3,135,000 for the 500,000 bushels of wheat. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the wheat futures price will have converged with the wheat spot price and will be equal to USD 6.2700/bu. As the long futures position was entered at a lower price of USD 5.7000/bu, it will have gained USD 6.2700 – USD 5.7000 = USD 0.5700 per bushel. With 100 contracts covering a total of 500,000 bushels of wheat, the total gain from the long futures position is USD 285,000.

In the end, the higher purchase price is offset by the gain in the wheat futures market, resulting in a net payment amount of USD 3,135,000 – USD 285,000 = USD 2,850,000. This amount is equivalent to the amount payable when buying the 500,000 bushels of wheat at USD 5.7000/bu.

Scenario #2: Wheat Spot Price Fell by 10% to USD 5.1300/bu on Delivery Date

With the spot price having fallen to USD 5.1300/bu, the bread maker will only need to pay USD 2,565,000 for the wheat. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the wheat futures price will have converged with the wheat spot price and will be equal to USD 5.1300/bu. As the long futures position was entered at USD 5.7000/bu, it will have lost USD 5.7000 – USD 5.1300 = USD 0.5700 per bushel. With 100 contracts covering a total of 500,000 bushels, the total loss from the long futures position is USD 285,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the wheat futures market and the net amount payable will be USD 2,565,000 + USD 285,000 = USD 2,850,000. Once again, this amount is equivalent to buying 500,000 bushels of wheat at USD 5.7000/bu.

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Risk/Reward Tradeoff

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

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

Learn More About Wheat Futures & Options Trading

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Hedging Against Rising Wheat Prices using Wheat Futures

Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.

For stock options, each contract covers 100 shares.

Buying Put Options

Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.

A Simplified Example

Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.

Let’s take a look at how we obtain this figure.

If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don’t own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.

This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.

Protective Puts

Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts.

Selling Put Options

Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.

Covered Puts

The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying.

Naked Puts

The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.

For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.

Put Spreads

A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader’s maximum loss at the expense of capping his potential profit at the same time.

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