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Center for Futures Education, Inc. | Three Reasons to Hedge

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:

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.

© 2007, Inc.

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