Hedging Against Rising Ethanol Prices using Ethanol Futures

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Contents

Hedging Against Rising Ethanol Prices using Ethanol Futures

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

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

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

Ethanol Futures Long Hedge Example

A motor fuel distributor will need to procure 2.90 million gallons of ethanol in 3 months’ time. The prevailing spot price for ethanol is USD 1.5800/gal while the price of ethanol futures for delivery in 3 months’ time is USD 1.6000/gal. To hedge against a rise in ethanol price, the motor fuel distributor decided to lock in a future purchase price of USD 1.6000/gal by taking a long position in an appropriate number of CBOT Ethanol futures contracts. With each CBOT Ethanol futures contract covering 29000 gallons of ethanol, the motor fuel 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 motor fuel distributor will be able to purchase the 2.90 million gallons of ethanol at USD 1.6000/gal for a total amount of USD 4,640,000. Let’s see how this is achieved by looking at scenarios in which the price of ethanol makes a significant move either upwards or downwards by delivery date.

Scenario #1: Ethanol Spot Price Rose by 10% to USD 1.7380/gal on Delivery Date

With the increase in ethanol price to USD 1.7380/gal, the motor fuel distributor will now have to pay USD 5,040,200 for the 2.90 million gallons of ethanol. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the ethanol futures price will have converged with the ethanol spot price and will be equal to USD 1.7380/gal. As the long futures position was entered at a lower price of USD 1.6000/gal, it will have gained USD 1.7380 – USD 1.6000 = USD 0.1380 per gallon. With 100 contracts covering a total of 2.90 million gallons of ethanol, the total gain from the long futures position is USD 400,200.

In the end, the higher purchase price is offset by the gain in the ethanol futures market, resulting in a net payment amount of USD 5,040,200 – USD 400,200 = USD 4,640,000. This amount is equivalent to the amount payable when buying the 2.90 million gallons of ethanol at USD 1.6000/gal.

Scenario #2: Ethanol Spot Price Fell by 10% to USD 1.4220/gal on Delivery Date

With the spot price having fallen to USD 1.4220/gal, the motor fuel distributor will only need to pay USD 4,123,800 for the ethanol. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the ethanol futures price will have converged with the ethanol spot price and will be equal to USD 1.4220/gal. As the long futures position was entered at USD 1.6000/gal, it will have lost USD 1.6000 – USD 1.4220 = USD 0.1780 per gallon. With 100 contracts covering a total of 2.90 million gallons, the total loss from the long futures position is USD 516,200

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the ethanol futures market and the net amount payable will be USD 4,123,800 + USD 516,200 = USD 4,640,000. Once again, this amount is equivalent to buying 2.90 million gallons of ethanol at USD 1.6000/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 ethanol buyer would have been better off without the hedge if the price of the commodity fell.

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

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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. ]

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Hedging Against Falling Ethanol Prices using Ethanol Futures

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

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

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

Ethanol Futures Short Hedge Example

An ethanol fuel producer has just entered into a contract to sell 2.90 million gallons of ethanol, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of ethanol on the day of delivery. At the time of signing the agreement, spot price for ethanol is USD 1.5800/gal while the price of ethanol futures for delivery in 3 months’ time is USD 1.6000/gal.

To lock in the selling price at USD 1.6000/gal, the ethanol fuel producer can enter a short position in an appropriate number of CBOT Ethanol futures contracts. With each CBOT Ethanol futures contract covering 29,000 gallons of ethanol, the ethanol fuel producer will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the ethanol fuel producer will be able to sell the 2.90 million gallons of ethanol at USD 1.6000/gal for a total amount of USD 4,640,000. Let’s see how this is achieved by looking at scenarios in which the price of ethanol makes a significant move either upwards or downwards by delivery date.

Scenario #1: Ethanol Spot Price Fell by 10% to USD 1.4220/gal on Delivery Date

As per the sales contract, the ethanol fuel producer will have to sell the ethanol at only USD 1.4220/gal, resulting in a net sales proceeds of USD 4,123,800.

By delivery date, the ethanol futures price will have converged with the ethanol spot price and will be equal to USD 1.4220/gal. As the short futures position was entered at USD 1.6000/gal, it will have gained USD 1.6000 – USD 1.4220 = USD 0.1780 per gallon. With 100 contracts covering a total of 2900000 gallons, the total gain from the short futures position is USD 516,200

Together, the gain in the ethanol futures market and the amount realised from the sales contract will total USD 516,200 + USD 4,123,800 = USD 4,640,000. This amount is equivalent to selling 2.90 million gallons of ethanol at USD 1.6000/gal.

Scenario #2: Ethanol Spot Price Rose by 10% to USD 1.7380/gal on Delivery Date

With the increase in ethanol price to USD 1.7380/gal, the ethanol producer will be able to sell the 2.90 million gallons of ethanol for a higher net sales proceeds of USD 5,040,200.

However, as the short futures position was entered at a lower price of USD 1.6000/gal, it will have lost USD 1.7380 – USD 1.6000 = USD 0.1380 per gallon. With 100 contracts covering a total of 2.90 million gallons of ethanol, the total loss from the short futures position is USD 400,200.

In the end, the higher sales proceeds is offset by the loss in the ethanol futures market, resulting in a net proceeds of USD 5,040,200 – USD 400,200 = USD 4,640,000. Again, this is the same amount that would be received by selling 2.90 million gallons of ethanol at USD 1.6000/gal.

Risk/Reward Tradeoff

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

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

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Writing Puts to Purchase Stocks

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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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What is the Put Call Ratio and How to Use It

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Understanding Put-Call Parity

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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. ]

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Hedging Against Rising Corn Prices using Corn Futures

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

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

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

Corn Futures Long Hedge Example

An ethanol producer will need to procure 5,000 tonnes of corn in 3 months’ time. The prevailing spot price for corn is EUR 129.25/ton while the price of corn futures for delivery in 3 months’ time is EUR 130.00/ton. To hedge against a rise in corn price, the ethanol producer decided to lock in a future purchase price of EUR 130.00/ton by taking a long position in an appropriate number of Euronext Corn futures contracts. With each Euronext Corn futures contract covering 50 tonnes of corn, the ethanol producer 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 ethanol producer will be able to purchase the 5,000 tonnes of corn at EUR 130.00/ton for a total amount of EUR 650,000. Let’s see how this is achieved by looking at scenarios in which the price of corn makes a significant move either upwards or downwards by delivery date.

Scenario #1: Corn Spot Price Rose by 10% to EUR 142.18/ton on Delivery Date

With the increase in corn price to EUR 142.18/ton, the ethanol producer will now have to pay EUR 710,875 for the 5,000 tonnes of corn. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the corn futures price will have converged with the corn spot price and will be equal to EUR 142.18/ton. As the long futures position was entered at a lower price of EUR 130.00/ton, it will have gained EUR 142.18 – EUR 130.00 = EUR 12.18 per tonne. With 100 contracts covering a total of 5,000 tonnes of corn, the total gain from the long futures position is EUR 60,875.

In the end, the higher purchase price is offset by the gain in the corn futures market, resulting in a net payment amount of EUR 710,875 – EUR 60,875 = EUR 650,000. This amount is equivalent to the amount payable when buying the 5,000 tonnes of corn at EUR 130.00/ton.

Scenario #2: Corn Spot Price Fell by 10% to EUR 116.33/ton on Delivery Date

With the spot price having fallen to EUR 116.33/ton, the ethanol producer will only need to pay EUR 581,625 for the corn. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the corn futures price will have converged with the corn spot price and will be equal to EUR 116.33/ton. As the long futures position was entered at EUR 130.00/ton, it will have lost EUR 130.00 – EUR 116.33 = EUR 13.68 per tonne. With 100 contracts covering a total of 5,000 tonnes, the total loss from the long futures position is EUR 68,375

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the corn futures market and the net amount payable will be EUR 581,625 + EUR 68,375 = EUR 650,000. Once again, this amount is equivalent to buying 5,000 tonnes of corn at EUR 130.00/ton.

Risk/Reward Tradeoff

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

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

Learn More About Corn 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:
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  • Binomo
    Binomo

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