Basic Facts About Commodity Hedging

Commodity Hedging

The increasing volatility of commodity prices in recent years, together with the resulting cost increases and planning uncertainties, has led to the active management of commodity risks becoming increasingly important in corporate directions. The current article examines some crucial questions. The MT4 indicators on Exness help every trader notice the smallest changes in commodity hedging. So, read on to find out the basic facts about commodity hedging!

Commodities Trading Market

Commodity trading companies are some of the most important in global capitalism, and despite this, most people have never heard of them.

Commodity trading firm advocates say the sharp rise in profits during unstable times is not indicative of a mischievous attitude, but underscores the indispensable role traders play in smoothing out disparities between supply and demand by seeking profitable arbitrage opportunities.

Without the traders, who are in a way a visible manifestation of the invisible hand, the situation would be much worse. Despite its superficial nature, this type of reasoning obscures the fact that the way commodity trading firms operate often encourages the instability that their trading activities purport to solve.

What’s Commodities Hedging?

Before being exploited by industrialists in the form of finished or semi-finished products, raw materials such as agricultural products (wheat, soya, etc.), metals (gold, silver, etc.), and energies (petroleum, etc.) are traded on the financial markets. A preserve of institutional investors, the commodity market is not regulated (Over the counter/OTC). Buyers and sellers negotiate there directly through specific contracts.

How Does Commodities Hedging Work?

Commodity trading involves buying and selling commodities in the spot market where the purchase or sale of commodities is settled immediately. And in the futures market where transactions result in payment and delivery at a later date.

A producer can thus sell part of his production forward, before it is extracted (or harvested). This forward sale allows them to know his selling price in advance, regardless of how market conditions change in the meantime.

Examples of Hedging

If a coffee producer sells his crop at a fixed price in May for delivery at the end of July, he will be protected from a possible fall in prices (and harmed if they rise). This mechanism also applies to oil, a company being able to negotiate the price of the raw material without waiting for fear of a surge in the price of kerosene, etc.

Broad Commodity Investing

The first particularity to note when one is interested in investing in commodities is the specificity of this sector. The underlying is not at all the same as for, for example, a title. The influences are different. With a weaker economy, general demand falls.

The prices too. This reduces the profitability of companies working in raw materials. This is what happened in early 2021, when the Covid-19 epidemic weighed on the economy and hit this sector hard. It was necessary to have extensive knowledge of the issue. The trading places were very specific and their access was restricted. In addition, each trader had to be specialized in a specific commodity and only trade that one, for example, soybeans or wheat.

Then, with the arrival of electronic platforms, everything became more democratic. However, there is a disparity between ultra-professionals, experts in raw materials, and new investors who are not experts in this field.

How Volatile Are Different Commodities

Since the value of an option is the sum of its intrinsic value and its time value, selling an option is equivalent to selling volatility. When volatility increases, the value of the option also increases. This translates into a higher expected return. When an investor buys a stock, he will seek to protect himself against the stock’s volatility — this is called a hedging strategy.

Since there are two types of options — calls and puts — and each type of option can be bought or sold, there are four possible positions. The value of an option is made up of its intrinsic value and its time value. Its value is influenced upwards by volatility. A structured product is composed of an optional part, if the volatility increases, the coupon offered will also increase.

How Do You Invest in Commodities?

It is difficult for a particular investor to invest in the commodity market where investors and speculators rain or shine. They are regularly accused of increasing price volatility.

Reminder: commodity market volatility peaked at the end of 2015 as fears of a decelerating global economy caused prices to fall across the board. The price of oil thus fell from 140 dollars to less than 30 dollars, the price of coal losing 1/3 of its value in the space of a few days.

The best way to invest in this market segment is still to bet on “trackers” (also called ETFs). Their objective is to replicate the price of raw materials in a passive way. It is also possible to invest via certain derivative products (warrants, turbos, certificates, etc.) if you are an experienced investor.

Conclusion

The above considerations show the great complexity of the risks to which companies that are highly dependent on raw materials are exposed. In the first place, it is not a question of developing the best possible cover, but rather of following a strategy that corresponds to the risk profile of the company and which is designed with all its services.

The effects of the measures taken on the overall risk and revenue of the company must be systematically quantified to remain convincing vis-à-vis all the shareholders and partners involved. The practice has shown that companies continue to underestimate the risks associated with raw materials and their impact on profitability because they often do not have sufficient experience in dealing with these complex issues.

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