4. Market Operations5. Orders And Price Analysis6. Hedging

Hedging Calculations
Hedging is based on the principle that cash prices and futures prices tend to move up and down together. Taking a position in the futures market opposite to the one taken in the cash market, offsets a hedger's risk of losses in one by ensuring gains in the other. In this manner, the investor is able to establish a price level for a cash market transaction that may not actually take place for several months and effectively protect himself from adverse price moves.

To review from an earlier chapter: buying a futures contract gives you a long futures position. A price increase would result in a futures gain. Selling a futures contract gives you a short futures position. A price decrease would result in a futures gain. There are two types of hedgers: the buyer or long hedger and the seller or short hedger.

Thus, there are effectively four scenarios for a hedge: it's either short or long, and the subsequent market price moves either down or up. Let's consider ethanol traded on the CBOT.

Net Result of Short Hedges
First, we'll look at the short hedge as prices decrease. It is May and an ethanol producer wants to hedge approximately 1.5 million gallons of his July production to guard against the possibility of falling prices. So he short hedges by selling 52 July ethanol futures contracts (a contract is for a railcar of 29,000 gallons on the CBOT) at \$1.28/gallon. Both cash and futures prices have subsequently fallen. On July 1, when the producer sells physical ethanol to the local terminal, the price he receives is \$1.15/gal. The producer simultaneously offsets his hedge, by purchasing July ethanol futures at \$1.20. The transaction looks like this:
 Cash Market Futures Market Basis May Receives cash forward (July) bid at \$1.18/gal Sells July ethanol futures at \$1.28/gal -.10 July Sells cash ethanol at \$1.15/gal in the spot Buys July ethanol futures at \$1.20/gal -.05
As a result, the hedger sold ethanol for cash on the forward market at \$1.15 (the July Cash Market box), gained 8 cents on the futures position (sold the future for \$1.28 and bought it back for \$1.20), so it was as if he sold the commodity for \$1.23.

Remember, though, this was a hedge, not a primary position. Let's say the ethanol producer believed that prices would hold up through July, and perhaps gain a little. He would have been right. Let's say that this hedge represents only half his capacity of 3 million gallons/month. If he decided in May to sell the other half of his July run at market price, then the results are a little different. He would have gotten \$1.15 on the cash market for half his stock. Average that out with the \$1.23 for the hedged half, and he has an average sale price of \$1.19/gallon.

Now let's look at a short hedge as the prices increase. Again it is May and our ethanol producer wants to hedge approximately 1.5 million gallons of his July production to guard against the possibility of falling prices. So he short hedges by selling 52 July ethanol futures contracts (a contract is for a railcar of 29,000 gallons) at \$1.25/gallon. By the last week of June, both cash and futures prices have fallen. On July 1, when the producer sells physical ethanol to the local terminal, the price he receives is \$1.15/gal. The producer simultaneously offsets his hedge, by purchasing July ethanol futures at \$1.20. The transaction looks like this:

 Cash Market Futures Market Basis May Receives cash forward (July) bid at \$1.20/gal Sells July Ethanol future at 1.25/gal -.05 July Sells cash ethanol at \$1.25/gal Buys July Ethanol futures at \$1.35/gal -.10 Change \$.05/gal gain \$.10/gal loss .05 loss
As a result, the hedger sold ethanol for cash on the forward market at \$1.25, lost 10 cents on the futures position, so it was as if he sold the commodity for \$1.15.

Again, this was a hedge, not a primary position. Let's say the ethanol producer believed that prices would hold up through July, and perhaps gain a little. He would have been right. Again, he has another 1.5 million gallons/month of capacity. If he decided in May to sell the other half of his July run at market price, then the results are a little different. He would have gotten \$1.25 on the cash market for half his stock. Average that out with the \$1.15 for the hedged half, and he has an average sale price of \$1.20/gallon.

It's not a coincidence that the average price per gallon in the first scenario and in the second scenario are so close: \$1.19 versus \$1.20. That's the whole point of the hedge: to eliminate downside risk while ensuring a reasonable net price. The trade-off is that it is as difficult to make a windfall as it is to lose one.

Net Result of Long Hedges
Now let's examine the other side – the long hedge. Again we'll look at the decreasing-price scenario first.

A gasoline refiner wants to hedge its anticipated July ethanol demand of 2.9 million gallons to protect against the possibility of increasing prices. Its trader enters into a hedge by buying 100 July ethanol futures contracts at \$1.28/gallon in May, then both cash and futures prices fall. When the trader buys ethanol in the cash market for \$1.05/gallon in July, the hedge is offset by selling July ethanol futures at \$1.20.

 Cash Market Futures Market Basis May Receives cash forward (July) offer Buys July ethanol futures -.10 from an ethanol marketing firm at \$1.28/gal at \$1.18/gal July Buys cash ethanol at \$1.05/gal Sells July ethanol futures -.15 at \$1.20/gal Change \$.13/gal gain

As a result, the trader buys ethanol in July at \$1.05, loses 8 cents in the futures market (buys at \$1.28, sells at \$1.20), so in effect has to pay \$1.13/gallon. Bear in mind, this is still better than the \$1.18 she would have paid on the cash market in May, although not as good as the \$1.05 she could have paid in July.

Now let's consider a market with increasing prices. The refiner's trader wants to hedge her client's 2.9 million-gallon July ethanol demand against the possibility of increasing prices. She does this by buying 100 July ethanol futures at \$1.25/gallon in May, then both cash and futures prices rise steadily. When the trader buys ethanol in the cash market for \$1.20/gal in July, she simultaneously offsets the hedge by selling July ethanol futures at \$1.35.

 Cash Market Futures Market Basis May Receives cash forward (July) offer at \$1.15/gal Buys July ethanol futures at \$1.25/gal -.10 July Buys cash ethanol at \$1.20/gal Sells July ethanol futures at \$1.35/gal -.15 Change \$.05/gal loss \$.10/gal gain .05 cent gain
The trader bought the ethanol for \$1.20 on the cash market, and realized a 10 cent gain in the futures market, so it was as if she paid only \$1.10/gallon. By using the futures market, the refiner's trader was able to effectively lock in a July purchase price of \$1.10/gal. In fact, the net purchase price again ended up being 5 cents better than was anticipated, due to the weakening basis.

Summary And Review

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