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
A buying hedge, for example, could take the form of an investor purchasing a futures contract to protect from increasing prices of the underlying asset or commodity. A futures contract is a legal agreement to purchase or sell an asset or commodity at a specific price at a predetermined future date.
To hedge is to protect, so, a hedge position is undertaken to reduce risk. In some cases the one placing the hedge owns the commodity or asset, while other times the hedger does not. The hedger makes a purchase or sale of the futures contract to substitute for an eventual cash transaction. Investors may use a buying hedge if they predict having a future need for a commodity, or is planning on entering the market for a particular commodity at some point in the future.
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 risk of using the buying hedge strategy is that if the price of the commodity drops, the investor may have been better off without buying the hedge.
Buying hedges are speculative trades and carry the risk of being on the wrong side of the market.