Hedging Against Falling Heating Oil Prices using Heating Oil Futures

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Contents

Hedging Against Rising Heating Oil Prices using Heating Oil Futures

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

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

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

Heating Oil Futures Long Hedge Example

A heating oil distributor will need to procure 4.20 million gallons of heating oil in 3 months’ time. The prevailing spot price for heating oil is USD 1.4777/gal while the price of heating oil futures for delivery in 3 months’ time is USD 1.5000/gal. To hedge against a rise in heating oil price, the heating oil distributor decided to lock in a future purchase price of USD 1.5000/gal by taking a long position in an appropriate number of NYMEX Heating Oil futures contracts. With each NYMEX Heating Oil futures contract covering 42000 gallons of heating oil, the heating oil distributor 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 heating oil distributor will be able to purchase the 4.20 million gallons of heating oil at USD 1.5000/gal for a total amount of USD 6,300,000. Let’s see how this is achieved by looking at scenarios in which the price of heating oil makes a significant move either upwards or downwards by delivery date.

Scenario #1: Heating Oil Spot Price Rose by 10% to USD 1.6255/gal on Delivery Date

With the increase in heating oil price to USD 1.6255/gal, the heating oil distributor will now have to pay USD 6,826,974 for the 4.20 million gallons of heating oil. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the heating oil futures price will have converged with the heating oil spot price and will be equal to USD 1.6255/gal. As the long futures position was entered at a lower price of USD 1.5000/gal, it will have gained USD 1.6255 – USD 1.5000 = USD 0.1255 per gallon. With 100 contracts covering a total of 4.20 million gallons of heating oil, the total gain from the long futures position is USD 526,974.

In the end, the higher purchase price is offset by the gain in the heating oil futures market, resulting in a net payment amount of USD 6,826,974 – USD 526,974 = USD 6,300,000. This amount is equivalent to the amount payable when buying the 4.20 million gallons of heating oil at USD 1.5000/gal.

Scenario #2: Heating Oil Spot Price Fell by 10% to USD 1.3299/gal on Delivery Date

With the spot price having fallen to USD 1.3299/gal, the heating oil distributor will only need to pay USD 5,585,706 for the heating oil. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the heating oil futures price will have converged with the heating oil spot price and will be equal to USD 1.3299/gal. As the long futures position was entered at USD 1.5000/gal, it will have lost USD 1.5000 – USD 1.3299 = USD 0.1701 per gallon. With 100 contracts covering a total of 4.20 million gallons, the total loss from the long futures position is USD 714,294

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the heating oil futures market and the net amount payable will be USD 5,585,706 + USD 714,294 = USD 6,300,000. Once again, this amount is equivalent to buying 4.20 million gallons of heating oil at USD 1.5000/gal.

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Risk/Reward Tradeoff

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

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

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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. ]

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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. ]

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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 Falling Crude Oil Prices using Crude Oil Futures

Crude Oil producers can hedge against falling crude oil price by taking up a position in the crude oil futures market.

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

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

Crude Oil Futures Short Hedge Example

An oil extraction company has just entered into a contract to sell 100,000 barrels of crude oil, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of crude oil on the day of delivery. At the time of signing the agreement, spot price for crude oil is USD 44.20/barrel while the price of crude oil futures for delivery in 3 months’ time is USD 44.00/barrel.

To lock in the selling price at USD 44.00/barrel, the oil extraction company can enter a short position in an appropriate number of NYMEX Brent Crude Oil futures contracts. With each NYMEX Brent Crude Oil futures contract covering 1,000 barrels of crude oil, the oil extraction company will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the oil extraction company will be able to sell the 100,000 barrels of crude oil at USD 44.00/barrel for a total amount of USD 4,400,000. Let’s see how this is achieved by looking at scenarios in which the price of crude oil makes a significant move either upwards or downwards by delivery date.

Scenario #1: Crude Oil Spot Price Fell by 10% to USD 39.78/barrel on Delivery Date

As per the sales contract, the oil extraction company will have to sell the crude oil at only USD 39.78/barrel, resulting in a net sales proceeds of USD 3,978,000.

By delivery date, the crude oil futures price will have converged with the crude oil spot price and will be equal to USD 39.78/barrel. As the short futures position was entered at USD 44.00/barrel, it will have gained USD 44.00 – USD 39.78 = USD 4.2200 per barrel. With 100 contracts covering a total of 100000 barrels, the total gain from the short futures position is USD 422,000

Together, the gain in the crude oil futures market and the amount realised from the sales contract will total USD 422,000 + USD 3,978,000 = USD 4,400,000. This amount is equivalent to selling 100,000 barrels of crude oil at USD 44.00/barrel.

Scenario #2: Crude Oil Spot Price Rose by 10% to USD 48.62/barrel on Delivery Date

With the increase in crude oil price to USD 48.62/barrel, the crude oil producer will be able to sell the 100,000 barrels of crude oil for a higher net sales proceeds of USD 4,862,000.

However, as the short futures position was entered at a lower price of USD 44.00/barrel, it will have lost USD 48.62 – USD 44.00 = USD 4.6200 per barrel. With 100 contracts covering a total of 100,000 barrels of crude oil, the total loss from the short futures position is USD 462,000.

In the end, the higher sales proceeds is offset by the loss in the crude oil futures market, resulting in a net proceeds of USD 4,862,000 – USD 462,000 = USD 4,400,000. Again, this is the same amount that would be received by selling 100,000 barrels of crude oil at USD 44.00/barrel.

Risk/Reward Tradeoff

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

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

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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 Falling Heating Oil Prices using Heating Oil Futures

Heating Oil producers can hedge against falling heating oil price by taking up a position in the heating oil futures market.

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

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

Heating Oil Futures Short Hedge Example

An oil refinery has just entered into a contract to sell 4.20 million gallons of heating oil, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of heating oil on the day of delivery. At the time of signing the agreement, spot price for heating oil is USD 1.4777/gal while the price of heating oil futures for delivery in 3 months’ time is USD 1.5000/gal.

To lock in the selling price at USD 1.5000/gal, the oil refinery can enter a short position in an appropriate number of NYMEX Heating Oil futures contracts. With each NYMEX Heating Oil futures contract covering 42,000 gallons of heating oil, the oil refinery will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the oil refinery will be able to sell the 4.20 million gallons of heating oil at USD 1.5000/gal for a total amount of USD 6,300,000. Let’s see how this is achieved by looking at scenarios in which the price of heating oil makes a significant move either upwards or downwards by delivery date.

Scenario #1: Heating Oil Spot Price Fell by 10% to USD 1.3299/gal on Delivery Date

As per the sales contract, the oil refinery will have to sell the heating oil at only USD 1.3299/gal, resulting in a net sales proceeds of USD 5,585,706.

By delivery date, the heating oil futures price will have converged with the heating oil spot price and will be equal to USD 1.3299/gal. As the short futures position was entered at USD 1.5000/gal, it will have gained USD 1.5000 – USD 1.3299 = USD 0.1701 per gallon. With 100 contracts covering a total of 4200000 gallons, the total gain from the short futures position is USD 714,294

Together, the gain in the heating oil futures market and the amount realised from the sales contract will total USD 714,294 + USD 5,585,706 = USD 6,300,000. This amount is equivalent to selling 4.20 million gallons of heating oil at USD 1.5000/gal.

Scenario #2: Heating Oil Spot Price Rose by 10% to USD 1.6255/gal on Delivery Date

With the increase in heating oil price to USD 1.6255/gal, the heating oil producer will be able to sell the 4.20 million gallons of heating oil for a higher net sales proceeds of USD 6,826,974.

However, as the short futures position was entered at a lower price of USD 1.5000/gal, it will have lost USD 1.6255 – USD 1.5000 = USD 0.1255 per gallon. With 100 contracts covering a total of 4.20 million gallons of heating oil, the total loss from the short futures position is USD 526,974.

In the end, the higher sales proceeds is offset by the loss in the heating oil futures market, resulting in a net proceeds of USD 6,826,974 – USD 526,974 = USD 6,300,000. Again, this is the same amount that would be received by selling 4.20 million gallons of heating oil at USD 1.5000/gal.

Risk/Reward Tradeoff

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

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

Learn More About Heating Oil 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. ]

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Free Trading Education!
    Free Demo Account!
    Perfect for Beginners!

  • Binomo
    Binomo

    2 place in the ranking!

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