What Is a Short Hedge?

A short hedge is an investment strategy used to protect against the risk of a declining asset price in the future. Companies typically use the strategy to mitigate risk on assets they produce and/or sell. A short hedge involves shorting an asset with a derivative contract that hedges against potential losses in an owned investment by selling at a specified price.

Key Takeaways

  • A short hedge is an investment strategy used to protect against the risk of a declining asset price in the future.
  • A short hedge can be used to protect against losses and potentially earn a profit in the future.
  • Commodity producers can seek to lock in a preferred rate of sale in the future by taking a short position.

Understanding a Short Hedge

A short hedge can be used to protect against losses and potentially earn a profit in the future. Agriculture businesses may use a short hedge, where "anticipatory hedging" is often prevalent.

Anticipatory hedging facilitates long and short contracts in the agriculture market. Entities producing a commodity can hedge by taking a short position. Firms in need of the commodity to manufacture a product will seek to take a long position.

Companies use anticipatory hedging strategies to manage their inventory prudently. Entities may also seek to add additional profit through anticipatory hedging. In a short-hedged position, the entity is seeking to sell a commodity in the future at a specified price. The firm seeking to buy the commodity takes the opposite position on the contract known as the long-hedged position. Companies use a short hedge in many commodity markets, including copper, silver, gold, oil, natural gas, corn, and wheat.

Commodity Price Hedging

Commodity producers can seek to lock in a preferred rate of sale in the future by taking a short position. In this case, a company enters into a derivative contract to sell a commodity at a specified price in the future. The company then determines the derivative contract price at which they seek to sell and the specific contract terms. The company typically monitors this position throughout the holding period for daily requirements.

Practical Example of a Short Hedge

Let's assume it's October and Exxon Mobil Corporation (XOM) agrees to sell one million barrels of oil to a customer in December with the sale price based on the market price of crude oil on the day of delivery. The energy firm knows that it can comfortably make a profit on the sale by selling each barrel for $50 after considering production and marketing costs.

Currently, the commodity trades at $55 per barrel. However, Exxon believes it could fall over the next few months as the trade war between the United States and China continues to pressure global economic growth. To mitigate downside risk, the firm decides to execute a partial short hedge by shorting 250 Crude Oil Dec. 2019 Futures contracts at $55 per barrel. Since each crude oil futures contract represents 1000 barrels of crude oil, the value of the contracts is $13,750,000 (250,000 x $55).

At the time of delivery to the customer in December, the oil price has fallen and now trades at $49. Exxon consequently covers its short position for $12,250,000 (250,000 x $49) with a profit of $1,500,000 ($13,750,000–$12,250,000). Therefore, the short hedge has offset the sale's loss caused by the decline in the oil price.