Hedging Against Falling Coal Prices using Coal Futures

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Contents

Hedging Against Rising Coal Prices using Coal Futures

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

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

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

Coal Futures Long Hedge Example

A power company will need to procure 155,000 tons of coal in 3 months’ time. The prevailing spot price for coal is USD 74.45/ton while the price of coal futures for delivery in 3 months’ time is USD 74.00/ton. To hedge against a rise in coal price, the power company decided to lock in a future purchase price of USD 74.00/ton by taking a long position in an appropriate number of NYMEX Coal futures contracts. With each NYMEX Coal futures contract covering 1550 tons of coal, the power company 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 power company will be able to purchase the 155,000 tons of coal at USD 74.00/ton for a total amount of USD 11,470,000. Let’s see how this is achieved by looking at scenarios in which the price of coal makes a significant move either upwards or downwards by delivery date.

Scenario #1: Coal Spot Price Rose by 10% to USD 81.90/ton on Delivery Date

With the increase in coal price to USD 81.90/ton, the power company will now have to pay USD 12,693,725 for the 155,000 tons of coal. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the coal futures price will have converged with the coal spot price and will be equal to USD 81.90/ton. As the long futures position was entered at a lower price of USD 74.00/ton, it will have gained USD 81.90 – USD 74.00 = USD 7.8950 per ton. With 100 contracts covering a total of 155,000 tons of coal, the total gain from the long futures position is USD 1,223,725.

In the end, the higher purchase price is offset by the gain in the coal futures market, resulting in a net payment amount of USD 12,693,725 – USD 1,223,725 = USD 11,470,000. This amount is equivalent to the amount payable when buying the 155,000 tons of coal at USD 74.00/ton.

Scenario #2: Coal Spot Price Fell by 10% to USD 67.01/ton on Delivery Date

With the spot price having fallen to USD 67.01/ton, the power company will only need to pay USD 10,385,775 for the coal. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the coal futures price will have converged with the coal spot price and will be equal to USD 67.01/ton. As the long futures position was entered at USD 74.00/ton, it will have lost USD 74.00 – USD 67.01 = USD 6.9950 per ton. With 100 contracts covering a total of 155,000 tons, the total loss from the long futures position is USD 1,084,225

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the coal futures market and the net amount payable will be USD 10,385,775 + USD 1,084,225 = USD 11,470,000. Once again, this amount is equivalent to buying 155,000 tons of coal at USD 74.00/ton.

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Risk/Reward Tradeoff

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

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Hedging Against Falling Coal Prices using Coal Futures

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

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

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

Coal Futures Short Hedge Example

A coal mining firm has just entered into a contract to sell 155,000 tons of coal, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of coal on the day of delivery. At the time of signing the agreement, spot price for coal is USD 74.45/ton while the price of coal futures for delivery in 3 months’ time is USD 74.00/ton.

To lock in the selling price at USD 74.00/ton, the coal mining firm can enter a short position in an appropriate number of NYMEX Coal futures contracts. With each NYMEX Coal futures contract covering 1,550 tons of coal, the coal mining firm will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the coal mining firm will be able to sell the 155,000 tons of coal at USD 74.00/ton for a total amount of USD 11,470,000. Let’s see how this is achieved by looking at scenarios in which the price of coal makes a significant move either upwards or downwards by delivery date.

Scenario #1: Coal Spot Price Fell by 10% to USD 67.01/ton on Delivery Date

As per the sales contract, the coal mining firm will have to sell the coal at only USD 67.01/ton, resulting in a net sales proceeds of USD 10,385,775.

By delivery date, the coal futures price will have converged with the coal spot price and will be equal to USD 67.01/ton. As the short futures position was entered at USD 74.00/ton, it will have gained USD 74.00 – USD 67.01 = USD 6.9950 per ton. With 100 contracts covering a total of 155000 tons, the total gain from the short futures position is USD 1,084,225

Together, the gain in the coal futures market and the amount realised from the sales contract will total USD 1,084,225 + USD 10,385,775 = USD 11,470,000. This amount is equivalent to selling 155,000 tons of coal at USD 74.00/ton.

Scenario #2: Coal Spot Price Rose by 10% to USD 81.90/ton on Delivery Date

With the increase in coal price to USD 81.90/ton, the coal producer will be able to sell the 155,000 tons of coal for a higher net sales proceeds of USD 12,693,725.

However, as the short futures position was entered at a lower price of USD 74.00/ton, it will have lost USD 81.90 – USD 74.00 = USD 7.8950 per ton. With 100 contracts covering a total of 155,000 tons of coal, the total loss from the short futures position is USD 1,223,725.

In the end, the higher sales proceeds is offset by the loss in the coal futures market, resulting in a net proceeds of USD 12,693,725 – USD 1,223,725 = USD 11,470,000. Again, this is the same amount that would be received by selling 155,000 tons of coal at USD 74.00/ton.

Risk/Reward Tradeoff

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

Learn More About Coal Futures & Options Trading

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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

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A Beginner’s Guide to Hedging

Although it might sound like something done by your gardening-obsessed neighbor, hedging is a useful practice that every investor should know about. In the markets, hedging is a way to get portfolio protection – and protection is often just as important as portfolio appreciation. Hedging, however, is often talked about broadly more than it is explained, making it seem as though it belongs only to the most esoteric financial realms. Even if you are a beginner, you can learn what hedging is, how it works, and what techniques investors and companies use to protect themselves.

Key Takeaways

  • Hedging is a risk management strategy employed to offset losses in investments.
  • The reduction in risk typically results in a reduction in potential profits.
  • Hedging strategies typically involve derivatives, such as options and futures.

What Is Hedging?

The best way to understand hedging is to think of it as a form of insurance. When people decide to hedge, they are insuring themselves against a negative event to their finances. This doesn’t prevent all negative events from happening, but something does happen and you’re properly hedged, the impact of the event is reduced. In practice, hedging occurs almost everywhere and we see it every day. For example, if you buy homeowner’s insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters.

Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging is not as simple as paying an insurance company a fee every year for coverage. Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade in another.

Technically, to hedge you would trade make off-setting trades in securities with negative correlations. Of course, nothing in this world is free, so you still have to pay for this type of insurance in one form or another. For instance if you are long shares of XYZ corporation, you can buy a put option to protect you from large downside moves – but the option will cost you since you have to pay its premium.

A reduction in risk, therefore, will always mean a reduction in potential profits. So, hedging, for the most part, is a technique not by which you will make money but by which you can reduce potential loss. If the investment you are hedging against makes money, you will have typically reduced the profit you could have made, but if the investment loses money, your hedge, if successful, will reduce that loss.

A Beginner’s Guide To Hedging

Understanding Hedging

Hedging techniques generally involve the use of financial instruments known as derivatives, the two most common of which are options and futures. We’re not going to get into the nitty-gritty of describing how these instruments work. Just keep in mind that with these instruments, you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.

Let’s see how this works with an example. Say you own shares of Cory’s Tequila Corporation (ticker: CTC). Although you believe in this company for the long run, you are a little worried about some short-term losses in the tequila industry. To protect yourself from a fall in CTC, you can buy a put option (a derivative) on the company, which gives you the right to sell CTC at a specific price (strike price). This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the put option.

The other classic hedging example involves a company that depends on a certain commodity. Let’s say Cory’s Tequila Corporation is worried about the volatility in the price of agave, the plant used to make tequila. The company would be in deep trouble if the price of agave were to skyrocket, which would severely eat into their profits. To protect (hedge) against the uncertainty of agave prices, CTC can enter into a futures contract (or its less-regulated cousin, the forward contract), which allows the company to buy the agave at a specific price at a set date in the future. Now, CTC can budget without worrying about the fluctuating commodity.

If the agave skyrockets above the price specified by the futures contract, the hedge will have paid off because CTC will save money by paying the lower price. However, if the price goes down, CTC is still obligated to pay the price in the contract and would have been better off not hedging.

Because there are so many different types of options and futures contracts, an investor can hedge against nearly anything, including a stock, commodity price, interest rate, or currency. Investors can even hedge against the weather.

Hedging is not the same as speculating, which involves assuming more investment risks to earn profits.

Disadvantages of Hedging

Every hedge has a cost; so, before you decide to use hedging, you must ask yourself if the benefits received from it justify the expense. Remember, the goal of hedging isn’t to make money but to protect from losses. The cost of the hedge, whether it is the cost of an option or lost profits from being on the wrong side of a futures contract , cannot be avoided. This is the price you pay to avoid uncertainty.

We’ve been comparing hedging to insurance, but we should emphasize insurance is far more precise. With insurance, you are completely compensated for your loss (usually minus a deductible). Hedging a portfolio isn’t a perfect science and things can go wrong. Although risk managers are always aiming for the perfect hedge, it is difficult to achieve in practice.

What Hedging Means to You

The majority of investors will never trade a derivative contract in their life. In fact, most buy-and-hold investors ignore short-term fluctuation altogether. For these investors, there is little point in engaging in hedging because they let their investments grow with the overall market. So why learn about hedging?

Even if you never hedge for your own portfolio, you should understand how it works because many big companies and investment funds will hedge in some form. Oil companies, for example, might hedge against the price of oil, while an international mutual fund might hedge against fluctuations in foreign exchange rates. An understanding of hedging will help you to comprehend and analyze these investments.

The Bottom Line

Risk is an essential yet precarious element of investing. Regardless of what kind of investor one aims to be, having a basic knowledge of hedging strategies will lead to better awareness of how investors and companies work to protect themselves. Whether or not you decide to start practicing the intricate uses of derivatives, learning about how hedging works will help advance your understanding of the market, which will always help you be a better investor.

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