General Theory - Hedging

Hedging
Not all futures trading is about moving goods to market.
Hedging, or entering into a transaction in order to reduce existing exposure to price fluctuations, is also a major component of trading volume.

SEE:
A Beginner's Guide To Hedging

Risk Reduction
Just about any trader can be a hedger at some point in time; it is a function more than a job description. If a trader already holds the physical goods or the futures contracts to deliver them, or else has the offsetting short position, then she might act as a hedger on her next trade. Hedging is done to decrease risk.

When you buy a
futures contract, you agree to pay a certain price for a given quantity of a good. The counterparty who sells the contract is agreeing to the same terms. However, over the months-long course of the contract, circumstances beyond the control of either party can occur that affect the spot price on the delivery date, causing it to vary wildly from the price anticipated in the contract. When that happens and neither the buyer nor seller has hedged positions, then someone is going to end up with a windfall and the other is going to be paying for it.

Hedging, then, has a stabilizing effect on commodities pricing.

Long Hedging
In a
long hedge, the hedger buys a futures contract. Typically, this is done by someone who adds value to the commodity: processors, manufacturers, exporters or anyone who is going to need a known quantity of a commodity at a fairly specific point in the future. These types of end user are commercial hedgers.

Suppose a large snack food company knows in July that, in September two months hence, it will need 50,000 bushels of corn to keep its tortilla chip factory running. The CBOT reports the following prices for 5,000-bushel contracts, denominated in cents/bushel:

  • Spot: 235
  • SEP: 246
  • DEC: 260

Domestic demand for corn is growing at a fairly constant rate; supply could keep up, but new markets, unfavorable weather and any number of other factors, could determine how much of the crop would be available to the tortilla chip market and at what price. Our snack food company doesn't have the facilities to store the corn available on the spot market at $2.35/bushel, but decides that the $2.46 price for September corn still provides a reasonable profit margin. The $2.60 December price, though, indicates that the spot price of corn will keep climbing at an accelerating rate, and $2.60 is far more than the processor is willing to pay for a bushel of corn.

So the company buys ten 5,000-bushel SEP contracts at 246 cents/bushel. In September, it turns out that the new spot price is 248 cents/bushel. Because of all the procedural complications of taking delivery of a futures contract, the company will sell the contract just before it expires. By this point, the futures price will equal the spot price and the company will be able to engage in what's called a reversing trade and sell the contract at 248 cents/bushel.

The company will then buy the 50,000 bushels of corn on the spot market.

If you do the math, you'll see that the hedger has apparently bought $124,000 worth of corn in September for an investment of $123,000 in July. Still, that's not a real $1,000 profit if you consider the company could have bought the same amount of grain for the lower price on the spot market at the time it bought the future. It merely eliminated the cost of storage while adding on transaction costs.

LOOK OUT!

The profit and loss in a deal like this is typically negligible. The transaction is more accurately viewed as an insurance policy. A long hedge protects a trader against unanticipated price rises. That did not occur in this example. The September spot price was only a couple cents higher than the market thought it would be two months earlier. If there had been a rash of tornadoes in the Midwest or a huge order placed by a large overseas trading partner, then September spot price could have risen to 260 cents/bushel, or even higher, and the company would have been very happy it had the long hedge.

Short Hedging
In a
short hedge, the hedger sells a futures contract in order to limit exposure to a price shortfall. Typically, this is done by farmers, miners or anyone who, for whatever reason, is holding the inventory (commercial hedgers).

In a short hedge, the hedger sells a futures contract. Assume you're an agent for the farming cooperative in Nebraska that grows the corn underlying the contract described above, in the section on long hedging. You would enter into the same deal as the tortilla chip maker, but your incentive would be to limit the risk if corn prices declined sharply. If a large expected order did not materialize, if a developing nation should suddenly dump lower-cost corn on the world market or if unusually favorable summer weather should cause a supply glut, you know that there are at least 50,000 bushels you can sell at a price you can live with.

LOOK OUT!
Mechanically, the short hedger sells the contracts at the futures price to open the hedge, then, essentially, buys it back at the prevailing spot price to close it.

Leverage


Related Articles
  1. Active Trading

    Grow Your Finances In The Grain Markets

    Hedging with futures can protect those who buy and sell commodities from adverse price movements.
  2. Insurance

    Futures Fundamentals: The Players

    The players in the futures market fall into two categories: hedgers and speculators. Hedgers Farmers, manufacturers, importers and exporters can all be hedgers. A hedger buys or sells in the ...
  3. Budgeting

    5 Grocery Items Affected By The Rising Price Of Corn

    These items have a direct relation to the production of corn, and may have rising prices this summer.
  4. Options & Futures

    How to Trade Futures Contracts

    Futures is short for Futures Contracts, which are contracts between a buyer and seller of an asset who agree to exchange goods and money at a future date, but at a price and quantity determined ...
  5. Personal Finance

    I Can't Believe It's Corn!

    The widespread use of corn spans from food additives to fuel, aspirin and windshield washer fluid. Find out where else it's used and the size of this growing industry.
  6. Options & Futures

    Trading Gold And Silver Futures Contracts

    If you are a hedger or a speculator, gold and silver futures contracts offer a world of profit-making opportunities.
  7. Options & Futures

    20 Investments: Futures Contract

    What Is It? As the name implies, futures are contracts on commodities, currencies, and stock market indexes that attempt to predict the value of these securities at some date in the future. ...
  8. Active Trading

    5 Economic Changes That Fatten Your Grocery Bill

    Global economic conditions are working to bloat our food costs. And for many, even the smallest increase in food prices can spoil the family budget.
  9. Stock Analysis

    Wheat And Corn's Four-Year Summer High

    Both corn and wheat prices continue to soar as the effects of the worst drought in over 25 years takes hold.
  10. Term

    The Difference Between Forwards and Futures

    Both forward and futures contracts allow investors to buy or sell an asset at a specific time and price.
RELATED TERMS
  1. Carrying Charge Market

    A futures market where contracts with maturities further into ...
  2. Buying Hedge

    A transaction that commodities investors undertake to hedge against ...
  3. Selling Hedge

    A hedging strategy with which the sale of futures contracts are ...
  4. Convergence

    The movement of the price of a futures contract towards the spot ...
  5. Short The Basis

    A futures strategy involving the purchase of a futures position ...
  6. Contract Unit

    The actual amount of the underlying asset represented by a single ...
RELATED FAQS
  1. How is the price of a derivative determined?

    Learn how different types of derivatives are priced, including how futures contracts are valued and the Black-Scholes option ... Read Answer >>
  2. How are futures used to hedge a position?

    Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is as an arrangement between ... Read Answer >>
  3. What is the difference between hedging and speculation?

    Hedging involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying ... Read Answer >>
  4. What are some securities that have spot rates?

    Learn about the types of assets that have spot rates, and understand how the spot rate is used to determine the fair market ... Read Answer >>
  5. Why do companies enter into futures contracts?

    Learn how companies use futures contracts for the purposes of hedging their exposure to price fluctuations as well as for ... Read Answer >>
  6. What kinds of derivatives are traded on an exchange?

    Learn about the different types of derivatives traded on exchanges, including options and futures contracts, and discover ... Read Answer >>
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center