Reposting this from the RE forum as it did not garner any input.
Curious as to whether or not anyone here has hedged materials costs with derivatives. Assuming lumber pricing will come down over the next year as the supply chain catches up with the demand following the COVID bubble, could you buy puts on lumber to recapture some of the current cost inflation? Thinking about how the airline industry has historically hedged against fuel costs.
Conceptually, it makes sense. I assume higher lumber costs equate to higher margins for you? You are trading one risk for others though.
1) Price risk. What strike(s) are you looking at? If you don't want to pay a massive premium, maybe you are willing though, for something that far out you are going to want to buy a pretty far out of the money put. What happens if futures prices fall, you lose some of your margin you are capturing now, but they don't fall far enough for the put to be in the money and it expires worthless as well? Also, I haven't looked at the implied vol curve of lumber options but I am willing to be the market has the same idea as you and puts are trading at a pretty high implied vol. I bet it will cost a pretty penny to buy at the money puts for that far out so then you have to ask yourself is it worth the premium you are paying?
2) Put liquidity. Is there enough liquidity to even cover your exposure at the strikes that fit your risk profile?
3) Volume risk. How much lumber are you going to use next year? Can you identify this number confidently? If you don't line up your volumes it could lead to losing both ways. You have to be able to quantify the gain you are currently seeing from increased local lumber costs before you can hedge away that potentially lost cash flow.
4) Basis risk. Futures and their derivatives are based on the delivery of that product at a certain location. If where you are building is far from that location then you could see your local lumber price stay flat while the futures continue to rise or local lumber prices fall while futures stay flat. In this case, you lose on both legs as well.
Having said all that, all of those aspects I highlighted as risks could move in your favor and you could win on both legs. Just something that needs to be taken into account.
I kinda figured it would be like a refiner with oil prices. Yeah you can pass on some of the higher cost, but the crack spread is generally lower when crude prices are higher.
Seems like the logic is backwards though, buying puts would double your risk.
if you’re a builder and buy lumber, you would already benefit from buying cheaper lumber in the future. If you want to hedge the risk of higher future costs, you would buy futures or calls to lock in the price today
Sounds right
the time/method to hedge (if you are a buyer of a commodity) is to buy the commodity (long the futures contract) before prices rise. After prices have risen, there is no way to hedge...you are just SOL.
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