Here we take a look at coverage activities in commodity trading, and because participants using this approach to protect their business.
Those who sell or to buy physical goods use the futures markets of products for security.
The idea is to protect their position in case of negative commodity prices moving against them.
Get free INO Trading alerts when you subscribe to our free Newsletter universe merchandise here. Simply fill out the simple form below. Is as easy as 1-2-3!So, for example, a manufacturer of high quality copper can to be sure that when the copper is delivered in three months time, will today's price for the metal is high.
As the copper market is always moving, with copper prices rising or falling, there is no certainty of getting the right price.
If the global demand for copper falls on the price of copper futures commodity markets such as the LME will reflect this and fall in value.
So copper producer would sell copper futures and make a profit on future contract to compensate for the lower price, which he will receive when the metal is delivered.
Or let s say that there is a company called Chiltern oil, which has a small onshore oilfield discovered in the United Kingdom, a great find in these times of ever-higher prices of crude oil, with 100,000 barrels of crude oil to be sold.
Chiltern oil wants to make sure that its light, sweet crude oil fetches a good price in a time of 8 months.
Today, the company could get around 110 dollars per barrel, but if the world economy slows and the benchmark NYMEX WTI crude futures headed south over the next eight months, the price may be just say $ 80.
Chiltern can sell its 100,000 barrels of crude oil on NYMEX to $ 110 and then relax and carry on with business as usual, without worrying that the price could fall in the coming months.
When it comes time to deliver the oil in the market, the price dropped to $ 78 per barrel, which is the lower revenue for the company.
But now you can liquidate their stock that has increased in value and thus compensate for the reduced revenue from selling physical with paper profits on the contract.
This method of protecting profits when a manufacturer sells a commodity in a market where the price is falling is called a Short Hedge.
Coverage in the trade of raw materials is a defensive mechanism to protect a position, not a method of making more money.
In other words, a way of managing risk or exposure to market volatility and price spikes or slumps.
When users protect their input costs
Let s look at it from the perspective of an end user, for example, a manufacturer of food or in our example, a factory of Chocolotta Limited, which makes the chocolate.
Chocolotta Limited gets most of its important ingredient cocoa from the Ivory Coast in Africa, a region that may be subject to civil unrest.
The company needs more cocoa in five months time, but needs certainty about how to pay for new supplies.
Today, in the month of July, the price is $ 1,650 per tonne of cacao, but who knows what will be 5 months out.
Chocolotta decides to buy futures contracts December 5 at $ 1700 ton, and as each contract is for 10 tons, the total futures contract is for $ 85,000.
Now the company has protected itself by a spike in cocoa prices in the period up to when you must make another purchase in the month of December.
Although there is a serious civil disorder in Cote d'Ivoire, cocoa prices which sends up to 2,000 dollars per tonne, Chocolotta will be useful on its cocoa futures that will compensate for the increased costs of entry.
This is how futures contracts provide a valuable way to protect end-users from volatile price movements and unexpected.
So when a company buys a futures contract in this way is referred to as a Hedge long.
When you are trading commodities as a speculator looking to make some profit, suffice to say that out there in the market there will be producers and sellers, trying to cover their positions, to avoid losses.
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