Hedging Against Falling Kerosene Prices using Kerosene Futures

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Contents

Hedging Against Falling Kerosene Prices using Kerosene Futures

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

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

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

Kerosene Futures Short Hedge Example

An oil refinery has just entered into a contract to sell 5,000 kiloliters of kerosene, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of kerosene on the day of delivery. At the time of signing the agreement, spot price for kerosene is JPY 45,710/kl while the price of kerosene futures for delivery in 3 months’ time is JPY 46,000/kl.

To lock in the selling price at JPY 46,000/kl, the oil refinery can enter a short position in an appropriate number of TOCOM Kerosene futures contracts. With each TOCOM Kerosene futures contract covering 50 kiloliters of kerosene, 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 5,000 kiloliters of kerosene at JPY 46,000/kl for a total amount of JPY 230,000,000. Let’s see how this is achieved by looking at scenarios in which the price of kerosene makes a significant move either upwards or downwards by delivery date.

Scenario #1: Kerosene Spot Price Fell by 10% to JPY 41,139/kl on Delivery Date

As per the sales contract, the oil refinery will have to sell the kerosene at only JPY 41,139/kl, resulting in a net sales proceeds of JPY 205,695,000.

By delivery date, the kerosene futures price will have converged with the kerosene spot price and will be equal to JPY 41,139/kl. As the short futures position was entered at JPY 46,000/kl, it will have gained JPY 46,000 – JPY 41,139 = JPY 4,861 per kiloliter. With 100 contracts covering a total of 5000 kiloliters, the total gain from the short futures position is JPY 24,305,000

Together, the gain in the kerosene futures market and the amount realised from the sales contract will total JPY 24,305,000 + JPY 205,695,000 = JPY 230,000,000. This amount is equivalent to selling 5,000 kiloliters of kerosene at JPY 46,000/kl.

Scenario #2: Kerosene Spot Price Rose by 10% to JPY 50,281/kl on Delivery Date

With the increase in kerosene price to JPY 50,281/kl, the kerosene producer will be able to sell the 5,000 kiloliters of kerosene for a higher net sales proceeds of JPY 251,405,000.

However, as the short futures position was entered at a lower price of JPY 46,000/kl, it will have lost JPY 50,281 – JPY 46,000 = JPY 4,281 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters of kerosene, the total loss from the short futures position is JPY 21,405,000.

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In the end, the higher sales proceeds is offset by the loss in the kerosene futures market, resulting in a net proceeds of JPY 251,405,000 – JPY 21,405,000 = JPY 230,000,000. Again, this is the same amount that would be received by selling 5,000 kiloliters of kerosene at JPY 46,000/kl.

Risk/Reward Tradeoff

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

Learn More About Kerosene Futures & Options Trading

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Hedging Against Falling Kerosene Prices using Kerosene 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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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

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Hedging Against Rising Kerosene Prices using Kerosene Futures

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

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

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

Kerosene Futures Long Hedge Example

A kerosene distributor will need to procure 5,000 kiloliters of kerosene in 3 months’ time. The prevailing spot price for kerosene is JPY 45,710/kl while the price of kerosene futures for delivery in 3 months’ time is JPY 46,000/kl. To hedge against a rise in kerosene price, the kerosene distributor decided to lock in a future purchase price of JPY 46,000/kl by taking a long position in an appropriate number of TOCOM Kerosene futures contracts. With each TOCOM Kerosene futures contract covering 50 kiloliters of kerosene, the kerosene 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 kerosene distributor will be able to purchase the 5,000 kiloliters of kerosene at JPY 46,000/kl for a total amount of JPY 230,000,000. Let’s see how this is achieved by looking at scenarios in which the price of kerosene makes a significant move either upwards or downwards by delivery date.

Scenario #1: Kerosene Spot Price Rose by 10% to JPY 50,281/kl on Delivery Date

With the increase in kerosene price to JPY 50,281/kl, the kerosene distributor will now have to pay JPY 251,405,000 for the 5,000 kiloliters of kerosene. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the kerosene futures price will have converged with the kerosene spot price and will be equal to JPY 50,281/kl. As the long futures position was entered at a lower price of JPY 46,000/kl, it will have gained JPY 50,281 – JPY 46,000 = JPY 4,281 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters of kerosene, the total gain from the long futures position is JPY 21,405,000.

In the end, the higher purchase price is offset by the gain in the kerosene futures market, resulting in a net payment amount of JPY 251,405,000 – JPY 21,405,000 = JPY 230,000,000. This amount is equivalent to the amount payable when buying the 5,000 kiloliters of kerosene at JPY 46,000/kl.

Scenario #2: Kerosene Spot Price Fell by 10% to JPY 41,139/kl on Delivery Date

With the spot price having fallen to JPY 41,139/kl, the kerosene distributor will only need to pay JPY 205,695,000 for the kerosene. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the kerosene futures price will have converged with the kerosene spot price and will be equal to JPY 41,139/kl. As the long futures position was entered at JPY 46,000/kl, it will have lost JPY 46,000 – JPY 41,139 = JPY 4,861 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters, the total loss from the long futures position is JPY 24,305,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the kerosene futures market and the net amount payable will be JPY 205,695,000 + JPY 24,305,000 = JPY 230,000,000. Once again, this amount is equivalent to buying 5,000 kiloliters of kerosene at JPY 46,000/kl.

Risk/Reward Tradeoff

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

Learn More About Kerosene Futures & Options Trading

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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. ]

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    1st Place! Best Binary Broker 2020!
    Best Choice for Beginners — Free Education + Free Demo Acc!
    Sign-up and Get Big Bonus:

  • Binomo
    Binomo

    2nd place! Good choice!

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