Hedging Against Falling Nickel Prices using Nickel Futures

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Good for Beginners!
    Free Education + Free Demo Account!
    Get Your Sign-Up Bonus Now!

  • Binomo
    Binomo

    Only For Experienced Traders!

Contents

Hedging Against Falling Nickel Prices using Nickel Futures

Nickel producers can hedge against falling nickel price by taking up a position in the nickel futures market.

Nickel producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of nickel that is only ready for sale sometime in the future.

To implement the short hedge, nickel producers sell (short) enough nickel futures contracts in the futures market to cover the quantity of nickel to be produced.

Nickel Futures Short Hedge Example

A nickel mining firm has just entered into a contract to sell 600 tonnes of nickel, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of nickel on the day of delivery. At the time of signing the agreement, spot price for nickel is USD 10,100/ton while the price of nickel futures for delivery in 3 months’ time is USD 10,000/ton.

To lock in the selling price at USD 10,000/ton, the nickel mining firm can enter a short position in an appropriate number of LME Nickel futures contracts. With each LME Nickel futures contract covering 6 tonnes of nickel, the nickel mining firm will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the nickel mining firm will be able to sell the 600 tonnes of nickel at USD 10,000/ton for a total amount of USD 6,000,000. Let’s see how this is achieved by looking at scenarios in which the price of nickel makes a significant move either upwards or downwards by delivery date.

Scenario #1: Nickel Spot Price Fell by 10% to USD 9,090/ton on Delivery Date

As per the sales contract, the nickel mining firm will have to sell the nickel at only USD 9,090/ton, resulting in a net sales proceeds of USD 5,454,000.

By delivery date, the nickel futures price will have converged with the nickel spot price and will be equal to USD 9,090/ton. As the short futures position was entered at USD 10,000/ton, it will have gained USD 10,000 – USD 9,090 = USD 910.00 per tonne. With 100 contracts covering a total of 600 tonnes, the total gain from the short futures position is USD 546,000

Together, the gain in the nickel futures market and the amount realised from the sales contract will total USD 546,000 + USD 5,454,000 = USD 6,000,000. This amount is equivalent to selling 600 tonnes of nickel at USD 10,000/ton.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Good for Beginners!
    Free Education + Free Demo Account!
    Get Your Sign-Up Bonus Now!

  • Binomo
    Binomo

    Only For Experienced Traders!

Scenario #2: Nickel Spot Price Rose by 10% to USD 11,110/ton on Delivery Date

With the increase in nickel price to USD 11,110/ton, the nickel producer will be able to sell the 600 tonnes of nickel for a higher net sales proceeds of USD 6,666,000.

However, as the short futures position was entered at a lower price of USD 10,000/ton, it will have lost USD 11,110 – USD 10,000 = USD 1,110 per tonne. With 100 contracts covering a total of 600 tonnes of nickel, the total loss from the short futures position is USD 666,000.

In the end, the higher sales proceeds is offset by the loss in the nickel futures market, resulting in a net proceeds of USD 6,666,000 – USD 666,000 = USD 6,000,000. Again, this is the same amount that would be received by selling 600 tonnes of nickel at USD 10,000/ton.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the nickel seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling nickel prices while still be able to benefit from a rise in nickel price is to buy nickel put options.

Learn More About Nickel Futures & Options Trading

You May Also Like

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 LEAPS® 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 LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [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. ]

Hedging Against Rising Nickel Prices using Nickel Futures

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

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

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

Nickel Futures Long Hedge Example

A steel manufacturer will need to procure 600 tonnes of nickel in 3 months’ time. The prevailing spot price for nickel is USD 10,100/ton while the price of nickel futures for delivery in 3 months’ time is USD 10,000/ton. To hedge against a rise in nickel price, the steel manufacturer decided to lock in a future purchase price of USD 10,000/ton by taking a long position in an appropriate number of LME Nickel futures contracts. With each LME Nickel futures contract covering 6 tonnes of nickel, the steel manufacturer 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 steel manufacturer will be able to purchase the 600 tonnes of nickel at USD 10,000/ton for a total amount of USD 6,000,000. Let’s see how this is achieved by looking at scenarios in which the price of nickel makes a significant move either upwards or downwards by delivery date.

Scenario #1: Nickel Spot Price Rose by 10% to USD 11,110/ton on Delivery Date

With the increase in nickel price to USD 11,110/ton, the steel manufacturer will now have to pay USD 6,666,000 for the 600 tonnes of nickel. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the nickel futures price will have converged with the nickel spot price and will be equal to USD 11,110/ton. As the long futures position was entered at a lower price of USD 10,000/ton, it will have gained USD 11,110 – USD 10,000 = USD 1,110 per tonne. With 100 contracts covering a total of 600 tonnes of nickel, the total gain from the long futures position is USD 666,000.

In the end, the higher purchase price is offset by the gain in the nickel futures market, resulting in a net payment amount of USD 6,666,000 – USD 666,000 = USD 6,000,000. This amount is equivalent to the amount payable when buying the 600 tonnes of nickel at USD 10,000/ton.

Scenario #2: Nickel Spot Price Fell by 10% to USD 9,090/ton on Delivery Date

With the spot price having fallen to USD 9,090/ton, the steel manufacturer will only need to pay USD 5,454,000 for the nickel. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the nickel futures price will have converged with the nickel spot price and will be equal to USD 9,090/ton. As the long futures position was entered at USD 10,000/ton, it will have lost USD 10,000 – USD 9,090 = USD 910.00 per tonne. With 100 contracts covering a total of 600 tonnes, the total loss from the long futures position is USD 546,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the nickel futures market and the net amount payable will be USD 5,454,000 + USD 546,000 = USD 6,000,000. Once again, this amount is equivalent to buying 600 tonnes of nickel at USD 10,000/ton.

Risk/Reward Tradeoff

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

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

Learn More About Nickel Futures & Options Trading

You May Also Like

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 LEAPS® 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 LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [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. ]

Hedging

The LME offers those at all stages of the metals supply chain the opportunity to hedge their price risk and gain protection from adverse price movements.

Hedging is the process of offsetting the risk of price movements in the physical market by locking in a price for the same commodity in the futures market.
There are two main motivations for a company to hedge:

  • To lock in a future price which is attractive, relative to an organisation’s costs
  • To secure a price fixed against an external contract

When hedging, an organisation starts with price risk exposure from its physical operations, and will buy or sell a futures contract to offset that price exposure in the futures market. An organisation can decide on the amount of risk it is prepared to accept. It may wish to eliminate price risk entirely.

To be successful, a hedging programme must be devised in conjunction with a sale or purchase plan, and all pricing must be basis the LME Official Settlement Price in order to achieve the most effective hedge and to meet the international accounting standards.

Speculation

Hedging is the opposite of speculation as its primary purpose is to offset risk. Speculators, however, come to the futures market with no initial risk. They assume risk by taking on futures positions, which in turn provides market liquidity. Hedgers reduce or eliminate the chance of future losses or profits, while speculators risk losses in order to make profits.

Hedging programme

To be successful, a hedging programme must be devised in conjunction with a sale or purchase plan, and all pricing must be basis the LME Official Settlement Price in order to achieve the most effective hedge and to meet the international accounting standards.

The programme can be as simple or as complex as a company wants to make it, but it will depend on that company’s appetite for risk, internal practices, pricing policies and hedging motives. Not only must a hedging programme be well devised, but it must also be managed according to the changing circumstances of a company’s physical operations.

Hedging example

The below example provides an overview of a typical offset hedge strategy conducted on the LME.

An offset hedge is designed to remove the basis price risk of the physical operation by offsetting it with an equal and opposite sale or purchase of a futures contract on the Exchange. Any risk of price volatility that arises from the physical transaction is thereby eliminated.

An offset hedge is a financial operation in which the hedger (the company hedging) maintains a ‘balanced book’ with each physical transaction being offset by an LME transaction. In this example both the buyer and the seller choose to hedge their price risk. However, it is not necessary for both parties to the physical transaction to hedge; this will depend entirely on their organisation’s internal practices and approach to risk management.

There are three main stages to the process:

1. Physical Transaction

A producer agrees to sell a specific quantity of physical material to a consumer for a delivery date in the future. For hedging to be successful for either party, the contract must be agreed basis the current LME Official Settlement Price.

Both the producer and the consumer are likely to be exposed to a change in price over the life span of the physical contract because the delivery date is in the future. Each company has the ability to hedge this exposure on the LME.

2. Financial Transaction

Once the physical transaction has been agreed the hedger will instruct their broker to open a futures contract on the LME. This will be made up of an equal and opposite position for the same delivery date as their physical transaction. This allows the hedger to lock in the future price and delivery date to match the physical contract already agreed.

Once an LME contract, or trade, has been entered and matched by the broker, a process known as ‘novation’ takes place. This is when the clearing house, LME Clear, becomes the counterparty to both sides of the trade. The brokers are now no longer exposed to the credit worthiness of each other and the financial risk of default is taken on by the clearing house.

When entering into a futures contract a hedger is required to make margin payments to their broker. This includes an initial margin at the outset and variation margin throughout the life of the contract. Variation margins are a form of collateral which provide daily security against any adverse price movements of a futures position. Margins are a regulatory requirement and are calculated by LME Clear, not the broker.

3. Settlement

Two days before the delivery date, the hedger will instruct their broker to financially settle the LME position by buying or selling back the original futures contract at the current LME Official Settlement Price.

In parallel to the financial transaction, the producer makes the physical sale of material to the consumer as agreed at the outset. Provided that this is agreed basis the current LME Official Settlement Price, the price risk of the base product over the period is eliminated for both parties, as the profits from one transaction offsets the losses from the other, and vice versa.

Producer benefits

LME contracts offer a number of benefits for producers, including the ability to:

  1. Offer a long-term fixed sales price and lock in a profit margin
  2. Use inventory financing and trade financing
  3. Access lower financing cost (banks view companies that hedge as lower risk)
  4. Protect the value of unsold inventory in a falling market
  5. Hedge physical purchases in times of strong demand.

The entire supply chain benefits from a transparent and accurate pricing mechanism.

Merchant benefits

LME contracts offer a number of benefits for merchants, including the ability to:

  1. Hedge physical sales and purchases
  2. Offer a long-term fixed sales price
  3. Swap physical material on a location and grade/producer basis
  4. Gain a competitive advantage by offering a fixed sales price
  5. Protect the value of physical stock against a fall in price
  6. Bring over-the-counter (OTC) transactions on Exchange.

The entire supply chain benefits from a transparent and accurate pricing mechanism.

Consumer benefits

LME contracts offer a number of benefits for consumers including the ability to:

  1. Lock-in a forward purchase price
  2. Accurate budgeting for raw material requirement costs
  3. Increased ability to commit to future sales prices

The entire supply chain benefits from a transparent and accurate pricing mechanism.

Scrap dealer benefits

LME contracts offer a number of benefits for a scrap recycler, including the ability to:

  1. Protect against price movements
  2. Offer long-term fixed sales price and lock in a profit margin
  3. Hedge the timing difference between scrap purchase and sale

The entire supply chain benefits from a transparent and accurate pricing mechanism.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Good for Beginners!
    Free Education + Free Demo Account!
    Get Your Sign-Up Bonus Now!

  • Binomo
    Binomo

    Only For Experienced Traders!

Like this post? Please share to your friends:
Binary Options Trading
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: