Basic Risk Management - Hedging

Two different motives compel commodities traders: speculation and hedging. They're not mutually exclusive - one can do both at the same time - but speculation is primarily profit oriented. Hedging is more oriented toward protecting profits or minimizing a potential loss, it's a defensive strategy.

Hedging is essentially recognizing a hard fact: traders can't predict prices correctly 100% of the time. In order to be on the right side of a trade, an investor needs not only to predict the direction of prices, but also to have good (or lucky) timing.

It isn't enough to guess correctly that prices are moving up or down, a trader has to know when to get in and when to get out. They can improve their odds on all those points by use of some simple hedging strategies.

First, some elementary concepts.

Hedging is effective, in part, 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 distinguished from the futures market where contracts are traded for future delivery of the good.

But they don't move exactly in lockstep. Any difference between the spot price and the current contract price is called the basis. Basis = cash price – futures price.

In any hedge investors have two basic alternatives: going short or going long. Many strategies involve a mixture of the two, they're not mutually exclusive, either. '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 first bought, and therefore don't own? In effect, by borrowing the commodity or contract from the broker, selling it, then buying the equivalent later on to 'balance the books'.

In going long a hedger benefits from a weakening basis, as the cash price falls relative to the equivalent futures contract. Shorting is advantageous when the basis is increasing, i.e. when the cash price rises relative to the futures contract price. Observe that a basis can rise or fall in opposition to price levels. It's the difference that matters.

A short example will help clarify the ideas.

Suppose a heating oil seller wants 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. By the last week of March, both cash and futures prices have fallen. On April 1, when the seller delivers heating oil to the local terminal, 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.)

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)