Avoiding the short squeeze: Hedge using financially settled futures contracts

Commodity risk management using pulp financial futures contracts

The short squeeze can be very painful. The term describes a phenomenon where a sharp upward price move forces traders who sold short to cover their positions.

Short squeezes do not discriminate and can happen in many commodity markets.

The pulp short squeeze

A short squeeze episode occurred in the Chinese pulp market in 2022. It started as China’s imported pulp market experienced supply restraints, with prices hitting a record high at $1010 per tonne for Northern Bleached Softwood Kraft in July.

The lack of pulp supplies had buoyed futures prices and escalated trading volumes beginning in August on The Shanghai Futures Exchange. The pulp futures contract offered by the SHFE is a physically delivered contract with specifications that allow twelve softwood pulp brands from Canada, Finland, Russia, Chile, and Sweden. The cheapest-to-deliver brands from Chile and Russia likely constitute most of the physical delivery.

According to statistics from China Customs, the country imported 4,796,017 tonnes of softwood pulp during the first eight months of 2022, down 17.08% year on year. The decline in softwood imports, which constitutes the physical delivery brands, started the ball rolling, leading to a short squeeze!

In hindsight, the short squeeze was not a surprise. Pulp market participants started to raise the issue with physical delivery, especially after the SHFE futures contract closed at 8174 yuan per tonne on September 9, 2022.

What is a short squeeze?

The term Short-Squeeze reflects rapidly rising prices in a tradeable asset. The short squeeze happens to the short sellers. A short seller is a person or company that places trades that increase in value if the price of the underlying assets declines. To short-sell an investment, you need to borrow the asset from another party and then sell the asset.

If you short-sell an asset and do not own the assets to deliver it back to the lender, you need to go into the open market and cover.

Physically delivered products such as pulp face the same issue. If a company or individual sells-short pulp futures, they will eventually have to either repurchase the futures contract or purchase physical pulp and comply with the sale that the futures contract requires.

What creates a short squeeze?

A confluence of events usually generates a short squeeze. The pulp short-squeeze was likely painful to those who did not have physical products to deliver and potentially caused realized losses.

The lack of delivery brands of softwood on the spot market exacerbated the upward pressure on total pulp prices.

How can you mitigate the impact of a short-squeeze in physically delivered contracts?

If a trader is contractually obligated to deliver an unavailable pulp brand, their concern can elevate quickly. The impact of fear can create a snowball effect, boosting prices and generating an unlimited theoretical cost to finding the appropriate delivery brands.

Why you might use financial settled futures contracts

One solution to avoiding a physical short-squeeze is to trade a financially settled futures contract. There are several benefits to financially settled futures contracts for your commodity risk management.

One advantage is that the settlement is against a financial benchmark. While the underlying asset price might surge more than you expected, you will only be responsible for the realized loss you experience by selling and covering (purchasing) the financial futures contract. You will never be put in a position where you have to deliver a physical product that might not be available.

Another advantage is that many financial futures contracts settle against the average price through a specific period.

For example, the NBSK Pulp Futures Contract (Fastmarkets) settles against the monthly average trading price of the Fastmarkets RISI NBSK CIF China price.

An average settlement price can significantly reduce the volatility of any individual price point. For example, during a month with 20 trading days, if the price of XYZ is $800 for 18 days of a month and then shoots to $1,000 for two days of the month, the average settlement price will be $820.

Instead of stopping out of the trade when the price jumped from $800 to $1,000, you might instead take the contract to the settlement, where the average caps your loss for the month.

Commercial pulp participants have additional risks if they hold physically delivered contracts beyond the 13th calendar month. There is an obligation that you will provide or receive the underlying asset.

The bottom line

One way to avoid the short squeeze created by a physically delivered futures contract is to hedge using financially delivered futures contracts. Contracts settle against several periods, including days, weeks, and months. More extended settlement periods, such as monthly settlements, tend to reduce the volatility of the returns of a futures contract.

If you what to learn more about hedging using financially settled futures contract or how hedging impacts your bottom line? Contact our Risk Solutions team.

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