Hedging with COMEX Copper futures

Hedging is essentially protection against negative price events.  Just as you protect your home, car or health, hedging guards against having to incur unforeseen or extra costs.  If properly hedged, changes in the underlying prices will be mostly offset by the hedge, thus protecting profit margin and asset value. 

The typical participants of a hedge strategy include the producers of the commodity, and the companies that needs to purchase that commodity sometime in the future. 

The physical product to be hedged, on which a derivatives product is based.

Derivatives are financial instruments whose prices move concurrently with the underlying asset, such as the COMEX Copper Futures contract. (Commodity code: HG)

Derivatives enable copper companies to obtain fixed-price solutions, reduce risk, lock in profits, and protect margins.

On July 1^st, 2020, a manufacturer of copper wire receives an order that it will not begin producing until January of 2021.  The manufacturer determines it will require approximately 2,500,000 pounds of copper to fulfill this order.

Instead of immediately purchasing all the necessary copper and incurring extra storage costs, the manufacturer decides to hedge the necessary material using COMEX Copper futures (HG).

The COMEX Copper Futures contract (HG) has a contract size of 25,000 pounds.  To hedge 2,500,000 pounds, the manufacturer, therefore, needs to purchase 100 HG futures contracts.

Current price of copper $3.80 per pound

Current January 2021 COMEX Copper futures price $3.83 per pound

On July 1^st, 2020, the manufacturer buys 100 January 2021 COMEX HG futures contracts (6 months forward) at $3.83 per pound.

On January 1^st, 2021, the manufacturer buys 2.5 million pounds of copper at $4.20 per pound (prevailing price at the time) and simultaneously sells 100 January 2021 COMEX Copper Futures contracts at $4.23 per pound.

In this example, the underlying price of copper has risen $0.40 per pound. Without hedging, the increase in the cost of purchasing the necessary copper is as follows:

2,500,000 X $0.40 =$1,000,000

This increase has been successfully offset by the purchase of COMEX Copper Futures as follows:

100 (contracts) X 25,000 (pounds) X $0.40 = $1,000,000

Profit margin is protected.

It is important to note that by hedging, a company is trying to mitigate risk, NOT make additional profit through speculation.  Therefore, if properly hedged, adverse and favorable price fluctuations will net the same result.