Commodity trading: A guide to hedging, futures contracts and zero-cost collars

If you spend time speaking to farmers, or any commodity producer, you know they are perpetually bullish. Farmers will store crops, speculating that prices will climb and become emboldened when commodity futures prices rise.

Irrational exuberance can sometimes get the best of of us. Determining when to sell is never easy. Farmers, oil producers and miners all want to lock in prices when they are high, but never want to sell too early.

The reverse is the case for consumers. When prices are falling, nobody seems to buy as prices might drop further. Fortunately, there are some ways that producers and consumers can hedge their commodity exposure without giving up their upsides.

What is hedging?

If the movements of commodity prices can impact your business, you might consider hedging to reduce your exposure. A hedge is an investment made to reduce the risk of adverse commodity price movements. Typically, your hedging strategy takes an offsetting position in a derivative or a related security.

For example, the run-up in agriculture products might induce you to sell your crops ahead of the harvest. You might consider a forward sale by entering into a contract with a buyer to sell your commodity at a fixed price once it is harvested. You also might hedge your crops or a portion of your crops using a futures contract that locks in your selling price.

A futures contract is an agreement to buy or sell a particular commodity at a predetermined price at a specified time in the future. Some futures contracts are physically delivered contracts where the seller must provide an asset to the buyer once the contract expires.

Other futures contracts are financially settled. The buyer pays or receives the difference between the price where the futures contract was purchased and where it was sold (or the settlement price at expiration).

One of the issues producers and consumers might experience with futures contracts is that they cannot participate in further upside for the volumes they hedge once transacted. You are fixing your selling (or buying) price for a specific volume. Any alternative to hedging using futures contracts is to use options strategies.

What are financial options?

An option is a right but not the obligation to purchase or sell a security for a specific price on or before a certain date. The option buyer pays the option seller a premium for the right to buy or sell an underlying security.

The right to purchase an asset is a call option, and the right to sell a commodity is called a put option. For example, if you grow corn and want to sell your crops, but do not want to be obligated to sell it, you can purchase a put option.

Options expire on a specific date. An option can be looked at as insurance, where you can pay a premium to make sure you can sell or buy a commodity at a specific price over a predefined period.

Option prices will fluctuate with market sentiment. Option premiums will also rise as volatility increases. For example, during geopolitical strife, supply uncertainty can generate significant volatility. The variable that reflects rising or falling volatility used to price an option is implied volatility. Implied volatility represents future volatility. If implied volatility increases, the costs of an option contract will also increase.

To avoid spending a lot of premium on an option that could eat into your profits, you could use a combination of options contracts referred to as a zero-cost collar, which can help you eliminate your premium costs.

What is a collar?

A collar is an options strategy where you sell one option and buy another. For example, let’s assume the price of corn is $7.5 per for settlement in three months, and you want to be able to sell at no less than $6 per bushel. To purchase a $6 put for free, you decide you are willing to give up any upside once the price exceeds $9 per bushel.

You have purchased a zero-cost collar if you sell a $9 call and buy a $6 put, and the premiums net out. If the price of corn drops below $6, you are protected from further downside. You will also participate in a price increase of up to $9 per bushel. The beauty of this strategy is you do not need to pay a premium, as the sale of the call offsets the cost of the put.
The picture of the payoff can make this easier to understand. You start to lose money on your hedge above $9, and you begin to gain below $6.

The strategy’s payoff chart shows that you experience losses from the short-call position above $9, offset by the gains of your physical corn holdings. As prices drop below $6, you generate income from the put offset by the losses from your physical holdings of corn.

The upshot is that a collar allows producers and consumers to continue participating in the commodity markets while locking in a hedged price to ensure robust cash flow.