Hedging Risks with Futures and Options

1. Eero A. Pikat President Barchart.com, Inc. Hedging Risks with Futures and Options

2. Barchart.com www.barchart.com is the largest futures-centric Internet financial portal, serving 30 million page views with 750,000 unique visitors / month Provides white-label content for numerous brokerage firms, media firms, and agribusinesses Provides realtime data, historical (time series data), end-of-day data to institutions and individuals Provides quotes, charts, news content, weather, and analysis to hundreds of third-party websites

3. Disclosure • WARNING: FUTURES AND OPTION TRADING INVOLVES HIGH RISKS AND YOU CAN LOSE A LOT OF MONEY. • When investing in futures, you may lose more than the funds you invested. When purchasing options, you may lose all of the money you invested. • Trading on commodity futures or options involves substantial risk of loss. According to many experts, most individual investors who trade commodity futures or options lose money. • Being a successful PAPER TRADER during one time period does not mean that you will make money when you actually invest during a later time period. Market conditions constantly change. • Notice: Hypothetical or simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since the trades have not actually been executed, the results may have under- or over- compensated for the impact, if any, of certain market factors, such as lack of liquidity. Hypothetical trading results are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. • If you are trading options, the futures charts are presented for informational purposes only. They are intended to show how investing in options can depend on the underlying futures prices; specifically, whether or not an option purchaser is buying an in-the-money, at-the-money, or out-of-the-money option. Furthermore, the purchaser will be able to determine whether or not to exercise his right on an option depending on how the option’s strike price compares to the underlying futures price. The futures charts are not intended to imply that option prices move in tandem with futures prices. In fact, option prices may only move a fraction of the price move in the underlying futures. In some cases, the option may not move at all or even move in the opposite direction of the underlying futures contract.

4. What are Commodities? • Things that are mined and/or drilled for • Oil, Natural Gas • Metals • Things that grow • Food (Corn, Soybeans, …) • Fiber (Lumber, Cotton, ….)

5. Futures vs Commodities • Commodities Cash (Spot) Market • Jewelry store for gold • Grain elevator for corn • Gas station for gas • (Generally) unregulated, lots of differences in price, quality, availability, etc.

6. Futures Markets • Regulated, centralized trading where quantity, quality (grade), delivery, dates are fully specified • Example: 1,000 barrels of Light Sweet Crude Oil, delivered at any pipeline or storage facility in Cushing, Oklahoma, which has pipeline access to TEPPCO, Cushing Storage, or Equilon Pipeline company • In short: highly specific trading unit • Futures expanded to “non-commodities” such as Dow Jones Futures, Interest Rates, Currencies

7. Mature Markets Intertwined • Mature markets co-mingle futures vs. cash • Ex: WTI Crude Oil price is actually the one on NYMEX, same with Gold • Grain Merchandisers at grain elevators use CBOT Corn price to determine their own prices • Why? • Uniform centralized price, absent of individual variances such as transportation costs, taxes, etc.

8. Hedging • What is hedging? • Reducing or eliminating risk (exposure) to market prices • Why do you want to hedge? • If you do NOT want to introduce market risk into your revenue/costs

9. Hedging • Who should hedge? • Anyone who wants to maintain risk-neutrality on market prices • Airlines for gas prices • Firms with foreign customers paying in different currencies • Manufacturing firms with exposure to raw materials, precious metals • Food companies

10. How? • Futures Contract • Specified Quantity • Specified Quality • Specified Place & Date of Delivery • Contract Value = Quantity x Price • Gold: $1,700 / oz x 100 oz = $170,000 • Mini Copper – 12,500 lbs x 3.30 = $41,250 • Micro CAD/USD - $10,000 x .9802 = $9,802

11. Futures Hedge • Find a contract that most closely matches your position, and buy/sell it • In general, you can “buy ahead” or “sell ahead”. So if you know you will be using 25,000 lbs of copper, you can buy it now. If someone is paying you €1,000,000 next year, you can sell them for U.S. Dollars now. • Difficulties matching size with need. The smallest copper contract is 12,500 lbs. • Sometimes there are complementary commodities: construction vs. weather

12. Futures Examples • Let's say a Canadian customer wants to pay you CAD$25,000 for a project. Currently, the price is .98 to 1 USD. That's $25,510 USD. But as recently as July, the CAD was at $1.05, which is $23,800. That's a $710 swing. To hedge: • “Buy the Canadian Dollar” (or “sell” the US Dollar today). • 2 E-Micro contracts. It's the same as buying CAD$20,000 today. So if the $USD goes down, you only lose 20% of what you would have lost.

13. Options • Alternative to Futures • Ability to accept (some) risk in return for reduced premium • 1 options contract converts to 1 futures contract • You buy the “right to buy” (call) or the “right to sell” (put) at a preset price • You pay a premium for this right

14. Options Example • On 9/25, when I created this slide, Gold was trading at $1,640 • A $1,700 call was selling for $6,540 • So, to protect yourself from gold going through the roof, it would cost you $12,540. $1,700 – $1,640 = 60 x 100 = $6,000 + $6,540 • Now if gold goes to $1,900, instead of losing $260 x 100 = $26,000, you only lose $12,540 • If gold goes down, you are out the $6,540. It's essentially insurance • Need to find right mix of price vs. premium vs. risk

15. Hybrid Futures + Option • Let's say you need to buy 1,000 lbs of copper in December • Problem: Main copper contract is 10,000 lbs • Solution: Buy 1 copper contract, sell 1 put option • Example: Copper is trading at $3.30 / lb • You would be paying about $3,300 for the copper • Find a Put option at around this price. Currently, there happens to be one at $3.28. This is the right to sell the copper at $3.28. • Buy the copper futures. If the futures go up, you gain, cent for cent. If the futures go down, your max loss is at $.02 x 25,000 or $500. (You would have paid the $3,300 anyway).

16. Summary • Use futures to fully offload risk. If you know you are going to be buying a specified quantity, and you need to price in today's dollars, buy it in today's dollars. If you know you are going to be selling something in the future, you can sell it in today's dollars • Use options as a form of insurance, where you pay a premium to lock in and limit your market exposure • If the price goes against you, that's fine. You are not a speculator. That's a different market, a different business. If you are in construction, why on earth are you speculating on interest rates, raw materials, etc. You shouldn't be trying to make money in the markets unless that's your business. Not having a proper hedge means that you are trying to make money in the markets, hoping copper goes down so that you pay less for it than what you quoted on a contract. • A good broker can help you find the right risk/reward