Commodities Trading Risk Management – Hedging Strategies
What is the difference between speculation and hedging, and how are they used in the financial industry? Speculation is essentially geared towards making profit while hedging is more a defense strategy geared towards protecting profits and minimizing loss.
Traders are unable to predict prices correctly 100% of the time, so hedging is basically recognizing that fact. Investors not only need to predict the correct direction of prices, they also need to have good (or fortunate) timing, to be on the right side of a trade.
A trader doesn’t just have to guess correctly when prices are moving up or down, they have to know when to get in and when to get out. Simple hedging strategies can can improve their odds on all those points.
Elementary Concepts
Hedging tends to be effective because prices in the cash (spot) markets and futures prices tend to move together. A 'spot' or cash market is one in which the physical commodity is bought and sold, as opposed to the futures market where contracts are traded for future delivery of the good.
However they don’t move in exact unison. Any difference between the spot price and the current contract price is called the basis. Basis = cash price – futures price.
There are two basic alternatives available with hedging: going short or going long. They’re not mutually exclusive so many strategies involve a combination of the two. 'Going long' means buying in order to sell later at a higher price. Going short involves selling before buying with the expectation of a future price decline.
Side note on going short: How do you sell something you haven't actually bought, and therefore don't own? In effect, by borrowing the commodity or contract from the broker, selling it, then buying the equivalent at a later stage to 'balance the books'.
A hedger gains from going long from a weakening basis, as the cash price falls relative to the equivalent futures contract. Shorting is beneficial when the basis is increasing, i.e. when the cash price rises relative to the futures contract price. Note that a basis can rise or fall in opposition to price levels. It's the difference that matters.
A short example will assist in clarifying the ideas.
A heating oil seller decides to hedge 50 percent of the anticipated April production of 3 million gallons.
The seller goes short by selling April heating oil futures contracts at $1.98/gal on March 1. Both cash and futures prices have fallen by the last week of March. When the seller delivers the heating oil to the local terminal on April 1, the price is $1.85/gal. The seller simultaneously hedges, by purchasing April ethanol futures at $1.90.
(The standard heating oil contract covers 42,000 gallons. The speculator would have to purchase 35.71 contracts. But partial contracts aren't traded. Figures are approximate for ease of demonstration.)
|
Date |
Spot Market |
Futures Market |
Basis |
|
Mar 1 |
$1.88 per gal. |
Sell April at $1.98 per gal. |
-$0.10 |
|
Apr 1 |
$1.85 per gal. |
Buy April at $1.90 per gal. |
-$0.05 |
Hedge Result:
Gain on the futures trades: $0.08 per gal. (Sell April at $1.98, Buy April at $1.90. $1.98 - $1.90 = $.08 or 8 cents)
Net sales price: $1.93 per gal. ($1.85 + $0.08)
|
Total
Result |
Price |
April
Income |
|
50%
hedged |
$1.93/gal |
$2,895,000
($1.93/gal. x 1.50 M gal.) |
|
50%
unhedged |
$1.85/gal |
$2,775,000
($1.85/gal. x 1.50 M gal.) |
|
April
average sale price |
$1.89/gal |
$5,670,000 |
Without hedging, what would the result have been? $1.85 x 3.0 million gallons would have procured the seller $5,550,000. So while hedging is most commonly used to minimize losses, it can be used to make profits, as indicated here by the net increase of April heating oil income of $120,000.
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