Case Study 20 : How a Kerala Merchant Used Derivatives and Recovered Losses Through Call Options

Background:
Ramesh Kumar, a grocery merchant in Kerala, specialized in importing essential commodities like rice, pulses, and edible oil. His business relied on consistent supply at predictable prices, but he was exposed to the volatility of commodity prices in global and domestic markets.

Initial Use of Derivatives:

To hedge against price fluctuations, Ramesh decided to use futures contracts in commodities. He entered into a futures contract for soybean oil at a price of ₹120/kg, anticipating a price increase due to a potential supply shortage. Unfortunately, contrary to his expectations, the global market experienced an oversupply, leading to a sharp decline in prices to ₹90/kg by the contract’s expiration.

Impact of Losses:

Ramesh suffered a significant financial loss because he had to honor the futures contract at ₹120/kg, while the prevailing market price was ₹90/kg. His margins were severely affected, and he faced cash flow challenges as customers preferred buying from competitors who sourced the oil at lower spot prices.

Recovery Through Call Options:

Realizing the importance of flexibility in risk management, Ramesh switched to using call options instead of futures for his next business cycle. Here’s how he did it:

1. Purchase of Call Options:
   Ramesh bought call options for rice and edible oil at a strike price close to the current market rate. For example, he bought a call option for edible oil with a strike price of ₹95/kg, paying a premium of ₹5/kg.
2. Market Conditions Worked in His Favor:
   Over the next few months, due to geopolitical tensions and erratic monsoon, the price of edible oil rose to ₹125/kg. Since he held a call option, Ramesh exercised it to buy the oil at ₹95/kg and profited from selling at the higher spot price of ₹125/kg. His net profit per kilogram was ₹25 (₹125 – ₹95 – ₹5 premium).
3. Risk Mitigation:
   Even if prices had fallen again, his losses would have been limited to the ₹5 premium he paid for the call option, ensuring financial stability.

Key Lessons Learned:

• Flexibility is Key: Unlike futures contracts, call options allowed Ramesh to limit his downside risk while retaining the potential for gains.
• Market Research: Ramesh invested in better market analysis tools and consulted experts to make informed decisions about strike prices and premiums.
• Diversification in Hedging: Ramesh diversified his use of derivatives across commodities and strike prices to balance his overall risk.

Outcome:

Ramesh recovered his initial losses and gained confidence in using derivatives as part of his risk management strategy. His business grew as he could offer competitive prices while ensuring a steady supply of essential commodities, cementing his reputation as a reliable grocery merchant in his region.

This case highlights how a small merchant can effectively use derivatives, particularly call options, to navigate market volatility and turn financial setbacks into opportunities for growth.