What is a 'Short Hedge'

A short hedge is an investment strategy utilized to protect against the risk of a declining asset price at some time in the future. It is typically focused on mitigating the risk of a current asset held by a company. The strategy involves shorting an asset with a derivative contract that hedges against potential losses in an owned investment by selling at a specified price.

BREAKING DOWN 'Short Hedge'

A short hedge can be used to protect against losses and potentially earn a profit in the future. Short hedges are often used in the agriculture business 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. Entities in need of the commodity to manufacture a product will seek to take a long position.

Companies use anticipatory hedging strategies to prudently manage their inventory. 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 entity seeking to buy the commodity takes the opposite position on the contract known as the long hedged position. Hedging is used in all types of 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 the short position. In this case a company would enter into a derivative contract to sell a commodity at a specified price in the future. The company would determine the derivative contract price at which they seek to sell and the detailed contract terms. The company is typically required to monitor this position throughout the duration of the holding for daily requirements.

Assume that an energy company would like to take a short position on the future value of oil. They would need to short the oil at a specified price. If the current price of oil is $30 per barrel and they want to hedge against any future losses, they may want to take a short position at $35 per barrel. Contracts are often structured to offer the price for multiple barrels. Therefore, the company would be selling 1,000 barrels at the price of $35 per barrel in one contract. If the contract is executed, the oil producer succeeds in mitigating losses and earns a targeted profit.

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