What is a 'Buying Hedge'

A buying hedge is a transaction which commodities investors undertake to hedge against possible increases in the prices of the actual materials underlying the futures contracts. This strategy is also known by many names including a long hedge, input hedge, a purchasers hedge, and a purchasing hedge.

BREAKING DOWN 'Buying Hedge'

Using a buying hedge by purchasing a futures contract will protect investors from the increasing prices of the underlying asset or commodity. A futures contract is a legal agreement to buy or sell a particular commodity or asset at a predetermined price at a specified time in the future. 

To hedge is to protect, so, a hedge position is undertaken to reduce risk. The hedger may or may not own the commodity associated with a given risk. They make the purchase or sale of the futures contract to substitute for an eventual cash transaction. Perhaps an investor has a future need for a commodity or expects to enter the market for that commodity at a later date. If so, they have a current position in it and may need to mitigate the risk that its price will move in a direction opposite their expectations.

Uses of a Buying Hedge

Many companies will use a buying hedge strategy to reduce the uncertainty associated with future prices for a commodity the need for production. The business will attempt to lock in the price of a commodity such as wheat, hogs, or oil.

Investors might use a buying hedge if they expect to buy a certain amount of the commodity in the future, but are worried about price fluctuations. They will buy a futures contract to be able to buy the commodity at a fixed price later. If the spot price of the underlying asset moves in a direction more beneficial for the holder, they can sell the futures contract and buy the asset at the spot price.

A buying hedge may also be used to hedge against a short position which has already been taken by the investor. The objective is to offset the investor’s loss in the cash market purchasing costs with a profit in the futures market. The downside of using the buying hedge strategy is that the buyer could be better off without buying the hedge if the price of the commodity falls.

Example of a Buying Hedge

The buying hedge can be an effective way of dealing with markets which have significant price volatility. For example, assume it is January, and an aluminum manufacturer needs 25,000 pounds of copper to manufacture aluminum and fulfill a contract in May. The current spot price is $1.50 per pound, but the May futures price is $1.40 per pound. In January the aluminum manufacturer would take a long position in 1 May futures contract on copper. This locks in the price the manufacturer will pay.

Later, if the May spot price of copper is $1.45 per pound the manufacturer has benefited from taking a long position because the hedger is paying $0.05/pound of copper compared to the current market price. However, if the price of copper were anywhere below $1.40 per pound, the manufacturer would be in a losing situation. 

Buying hedges are speculative trades and carry the risk of being on the wrong side of the market. 

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