What is a Selling Hedge
A selling hedge refers to any of a number of investment strategies involving contracted bets on prices at some time in the future for the purpose of hedging against potential losses and creating potential gains.
Also known as a "short hedge."
BREAKING DOWN Selling Hedge
A selling hedge takes a bet on the movement of prices in the future. It can involve any type of derivative instrument that allows for a contracted price at a future date. A selling hedge is a one-legged position. It is commonly constructed using futures on commodities or options on stocks.
In a selling hedge the investor typically owns the underlying asset at the time of the hedge. In taking on a one-legged position, the investor is open to the risks associated with the underlying asset up until the exercise date, and there is no guaranteed profit.
Futures and Commodities
Energy and agricultural companies will often enter into a selling hedge to manage the selling price of commodities at some time in the future. An oil company, for example, has some latitude to store additional oil inventory in order to seek higher profits. When a company identifies a price for its oil in the futures market, it will then enter into a futures contract at the future market price.
Perhaps oil three months out is trading at $75 per barrel while only selling at $65 per barrel in the current market. An oil company could buy a futures contract allowing for the sale of 100 barrels at $75 each. Entering into the contract ensures that the company can sell the inventory at $75 per barrel. As long as the price remains below $75 the company will profit. If the price exceeds $75 at the time of exercise, the company foregoes some profits it could have attained without the selling hedge.
Put Options and Stocks
Similar scenarios occur in the stock market with put options. Put options provide an investor with the opportunity to contract a sale at a future date. In the case of a selling hedge, the investor is taking a bet on stock they already own. Since they believe the stock’s value will be lower at a future date, they can write a put option contracting to sell the stock in the future.
For example, say an investor is bearish on a stock that has flatlined at $105 and wants to protect from any further losses that may occur in the future. They could potentially enter into a three-month put option, selling the stock to a buyer who is willing to pay $125 in the future. The stock owner stands to break even or gain as long as the price decreases or approaches $125 over the next three months. At exercise their full cost would include the profit minus the price of trading the put option contract. Therefore, a $1 put option cost would require the stock to rise to no higher than $124 at exercise. If the stock were to rise beyond that, the transaction would have some foregone earnings.