Hedging with Lumber futures
Lumber prices, like most commodities, are constantly fluctuating based on various market conditions. If you have exposure to the physical market, how can you manage this price risk if you are uncertain about the price moving up or down?
One way market participants such as sawmills, wholesalers, distributors, and builders can mitigate this risk is by hedging using Lumber futures and options contracts. Lumber futures and options contracts are financial instruments whose where prices tend to move in line with the prices of their underlying market.
Price increase example
In the early spring, a medium- sized home construction company knows it will be framing out a new subdivision, and they will need just over half a million board feet of softwood lumber for the summer. They are worried prices may increase when it comes time to purchase the needed materials, so they use Lumber futures as a hedge to mitigate this risk.
A single CME Group Lumber futures contract has a contract size of 27,500 board feet. To hedge the full order of new homes, needing about half a million board feet, the construction company can purchase 20 Lumber futures contracts.
Let’s assume in March, the cash price for lumber is $500/mbf and the futures price is $600/mbf.
To hedge their summer lumber purchase, the construction company will buy, or go long, 20 July Lumber futures contracts. Fast forward to July, and we see prices have increased. The cash price of lumber has moved to $700/mbf. Since cash prices and futures prices are highly correlated, we see the futures contract price has also increased to $800/mbf.
The increase in the cash prices means the construction company will pay more for its physical lumber, but they are also able to sell the futures position at a profit, which offsets the cash loss.
Without hedging with the Lumber futures contract, the builder would be subject to an overall price increase of $200.00.
Price decrease example
A sawmill selling physical lumber could take a short position, or sell futures, to protect against a decrease in price.
If cash prices fall and the sawmill sells their lumber for less money, those losses could be mitigated by profits from the futures position.
In this case they sold July futures at $800/mbf and purchased that position when the price was $600/mbf for a futures profit of $200.00.
It is important to note that hedging is a method to help mitigate future price risk. Hedging is not a technique to create additional profits. Therefore, when properly hedged, adverse and favorable price fluctuations will net the same result of a loss in one market and a gain in the other.
For more information on how to manage risk using Lumber futures and options, contact a broker or find one a broker in CME Group’s Broker Ddirectory for Lumber products found at cmegroup.com/lbr.
Test Your Knowledge
What did you think of this course?
To help us improve our education materials, please provide your feedback.