Three Reasons to Hedge
Hedgers shun the risk of price change and look for ways to transfer it, while speculators assume the risk of price change by taking one position (either long or short) in a market, and waiting for the price of their commodity to go in "their" direction. Hedgers, on the other hand, have a position, either long or short, usually in the cash market, and attempt to limit their risk of price change loss by entering into an opposite and approximately equal position in another market (usually futures or options).
A short hedger is someone who has a long position (owns the commodity) in the cash market and transfers the risk of price decline by selling a futures contract or buying a put option. If the cash market price declines and the futures market price also declines, the loss he suffers in the cash market will be offset by the gain he realizes in the futures market—at least that's the plan! Of course, it's likely that the cash and futures prices won't move exactly in tandem, in which case the short hedger may either achieve a better or worse price than he targeted when he entered the hedge.
Take, for example, a farmer growing his crop. As harvest time approaches, reality starts to set in, and the farmer realizes that he isn't the only one about to harvest a crop, so he wonders how low his crop's price will go as the large harvest supply reaches the market. At this point, he says, "Gee, I wish I knew more about hedging, but it sounds so scary."
What some people find scary is the “volatility” of the futures markets; however, the futures markets are no more volatile than the cash markets. In fact, futures markets are so liquid, that they are actually less volatile and cash market prices generally key off them. Furthermore, futures prices are easily determined and widely published.
So why not use futures to hedge? Hedging has the following three advantages to offer:
- Price risk transfer. Cash market prices change and there’s nothing you can do about it. What’s more, they’re going to keep changing, no matter what you do. So you have three choices: assume the risk of price change (be a speculator), transfer the risk of price change to a speculator (be a hedger), or get out of the market.
To be a hedger, you must have a cash market position (you must have a position to hedge). You must either produce a commodity, such as cotton, corn, or crude oil, use a commodity, such as silver, soybeans or sugar. If you produce a commodity, you have a “long” cash market position. As a speculator with a long cash market position, you want prices to rise because you are either storing the commodity for sale at a later date or you expect to supply the commodity for sale at a later date. By holding the commodity until it hits a higher price and then selling, you earn a profit.
Unfortunately, the market prices don’t always cooperate with buyers and sellers. How often do you think the price of a given commodity is going to be at its annual high when you’re ready to sell? Or at its annual low when you’re ready to buy? Because many commodities are seasonal, most commodity producers would agree: the answer is “never.” So what can you do?
Instead of waiting until you have the cash market product in hand, you can do a “substitute sale” in the futures market—this is also called “hedging.” This means that you sell now in the futures market, substituting your actions in the futures market today for what you will do in the cash market later. Of course, the trick is to “substitute” a better price today for a worse price that you would have to accept in the cash market in the future. By selling today at a higher price, you lock in a sales price (except for possible changes in basis—the difference between cash and futures prices), thus reducing your risk of loss from price changes. Because cash market prices and futures market prices tend to move together, if you substitute a sale today in the futures market for a later one in the cash market, then if prices do go down, as you expect them to, you can buy back the futures at a lower price than you sold them, pocketing a profit that approximately covers the opportunity price you missed in the cash market. When you close your futures position, you market your cash commodity the same way you always have done.
On the other hand, people who have a need for a commodity at some point in the future can do a "substitute purchase" in the futures market. This is also called hedging, and the person who is in such a position is a long hedger. Long hedgers buy now in the futures market to cover an anticipated need for the commodity in the future—they are short the cash commodity they will need later. They hope to substitute a better price today for a worse price they would have to accept in the cash market in the future. By buying today at a lower price, they reduce their risk of loss from price changes. If prices increase as expected, long hedgers sell the futures at a higher price than they were purchased, pocketing a profit that approximately offsets the higher cost of the cash commodity purchased in the usual way.
- Profit potential. It is possible (but not guaranteed) that after a short hedge has been put in place, both the cash and futures prices will drop, with the futures price dropping more than the cash price. This is a “favorable” change in basis. If this happens, the futures position more than offsets the loss in the cash market, thus earning a profit greater than that originally targeted. That can’t happen if you simply forward contract for the sale of your commodity. Of course, the opposite could also occur (futures price dropping less than the cash price), bringing in less than originally targeted.
Similarly, after a long hedge has been put in place, both the cash and futures prices may rise, with the futures price rising more than the cash price. This is a "favorable" change in basis. If this happens, the futures position more than offsets the loss in the cash market, thus reducing costs more, for a profit greater than that originally targeted. That can’t happen if you simply forward contract for the purchase of your commodity. Of course, the opposite could also occur (futures price rising less than the cash price), costing more than originally targeted.
- Cash Flow Smoothing. If you establish a hedge six months before your cash market transaction and then prices move unfavorably, your futures market position will start to earn you cash in the short run. The reason is that futures positions are “marked to the market” daily: if your futures position has a gain during today’s trading, the gained amount will be deposited to your account at the close of business today. This cash may help your cash flow until your cash market transaction. By providing a positive cash flow, overall operations may be easier to plan and less stressful to manage. It can also help to establish a better relationship with your banker because bankers prefer to work with the less-risky hedger rather than the riskier speculator.
Some people still object to hedging, in spite of these benefits, on the grounds that there is unlimited risk associated with a futures position. Perhaps they don't realize that, for hedgers, any money lost in the futures market is probably offset by gains enjoyed in the cash market. Maybe it was for these people that options on futures were invented.
There are two types of options: calls and puts. When you buy a call, you are buying the right to take delivery of something (let’s say one futures contract for 5,000 troy ozs. of silver) at a specific price (let’s say $13.50 per troy oz.) within a certain time (if it’s an October call, exercise of the option [and subsequent delivery of the underlying futures contract] must occur before the option expires in September). If the price of the underlying futures contract (which reflects the price of silver) goes up before the call expires, the call’s value may also go up. On the other hand, if the price of silver goes down, the call’s value will probably decline. (If this price/time relationship is of interest to you, you may want to read more about the time value and intrinsic value of options—see Making Sense of Futures Options, available from Center for Futures Education, Inc.)
On the other hand, purchasing a put gives you the right to deliver (sell) something (let’s say one futures contract for 100 troy ozs. of gold) at a specific price (let’s say $660.00 per troy oz.) within a certain time (if it’s an October put, delivery must occur before the option expires in September). If the price of the underlying futures contract (which reflects the price of gold) goes down before the put expires, the put’s value can go up. On the other hand, if the price of gold goes up, the put’s value will probably go down. In short, a speculator who buys a gold put wants to see the price of gold drop as fast as possible (the faster, the better). Conversely, the cash market seller who hedges his holdings by purchasing a put, may not care what happens to the price of gold. He’s going to gain from his cash commodity sale if the gold price goes up and, depending on how quickly the price drops, he can gain from his put.
While there is a lot to learn if you want to hedge properly, either with futures contracts or options on futures, it can be worth your while. The risk reduction potential is sizeable, and the cash flow smoothing effects from hedging consistently, year in and year out, allow for longer-term planning, an overall better profit margin, and less stress. Hedging sure can beat speculating in the cash market.
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