What is a Long Hedge
A long hedge refers to a futures position that is entered into for the purpose of price stability on a purchase. Long hedges are often used by manufacturers and processors to remove price volatility from the purchase of required inputs. These input-dependent companies know they will require materials several times a year, so they enter futures positions to stabilize the purchase price throughout the year. For this reason, a long hedge may also be referred to as an input hedge, a buyers hedge, a buy hedge, a purchasers hedge or a purchasing hedge.
BREAKING DOWN Long Hedge
A long hedge represents a smart cost control strategy for a company that knows it needs to purchase a commodity in the future and wants to lock in the purchase price. The hedge itself is quite simple, with the purchaser of a commodity simply entering a long futures position. A long position means the buyer of the commodity is making a bet that the price of the commodity will rise in the future. If the good rises in price, the profit from the futures position helps to offset the greater cost of the commodity.
Example of a Long Hedge
For a simplified example of a long hedge, 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 $2.50 per pound, but the May futures price is $2.40 per pound. In January the aluminum manufacturer would take a long position in a May futures contract on copper.
This futures contract can be sized to cover part or all of the expected order. Sizing the position sets the hedge ratio. For example, if the purchaser hedges half the purchase order size, then the hedge ratio is 50%. If the May spot price of copper is over $2.40 per pound, then the manufacturer has benefited from taking the long position. This is because the overall profit from the futures contract helps offset the higher purchasing cost paid for copper in May. If the May spot price of copper is below $2.40 per pound, the manufacturer takes a small loss on the futures position while saving overall thanks to a lower-than-anticipated purchasing price.
Long Hedges and Short Hedges
Basis risk makes it very difficult to offset all pricing risk, but a high hedge ratio on a long hedge will remove a lot of it. The opposite of a long hedge is a short hedge, which protects the seller of a commodity or asset by locking in the sale price. Hedges, both long and short, can be thought of as a form of insurance. There is a cost to setting them up, but they can save a company a large amount in an adverse situation.