If you're a commodities trader or are looking to become one, you know that two elements motivate you: speculation and hedging. Although speculation and hedging are not mutually exclusive and you can do both at the same time, speculation is primarily profit oriented. Hedging is more about protecting your profits or minimizing a potential loss and is therefore a defensive strategy.
When you hedge, you essentially recognize a hard fact; that is, traders cannot predict prices correctly all of the time. If you want to be on the right side of the trade, you need to not just to predict what direction prices are going to go in, but you also need good timing.
Although it's important to guess correctly whether prices are going to move up or down, you also have to know when you should get in and when you should get out. You can improve your odds of doing so with some simple hedging strategies.
To begin with, let's talk about a few elementary concepts. Hedging is effective, in part, because prices for commodities in the cash -- i.e., spot -- markets tend to move together, whether up or down.
In a "spot" or cash market, physical commodities are bought and sold. This differs from the futures market, where contracts are traded for future delivery of the particular commodity.
Even so, spot prices don't move exactly together. The difference between the spot price and the current contract price is called the "basis." The basis equals the cash price minus the futures price.
When they hedge, investors have two basic alternatives, either going short or going long. However, these two strategies are not used only to the exclusion of each other. They can be used together in a mixture, tailored to an investor's needs. If you "go long," that means you're buying in order to sell later at a higher price. If you "go short," that means that you're going to sell before you buy, and expect that the particular commodity will have a future price decline.
In regard to going short, it might confuse you to think that you're actually going to sell something you haven't bought first and therefore don't own. However, when you go short, you borrow the commodity or contract from the broker, sell it, and then buy the equivalent later to "balance the books."
When you go long, you hedge based upon a weakening basis as the cash price falls in relation to the public futures contract. Going short gives you the advantage when the basis is increasing; that is, when the cash price rises relative to the futures contract price. It should be noted that a basis can rise or fall in opposition to price levels. What matters is the difference between the two.
To clarify, let's look at the following:
Let's say a heating oil seller wants to hedge 50% of the anticipated April production of three million gallons. The seller goes short by selling the April heating oil futures contracts at $1.98 per gallon on March 1. By the end of March, cash and futures prices both have fallen. This means that on April 1, when the seller delivers heating oil to the local terminal, the price has fallen to $1.85 per gallon. The seller then simultaneously hedges by purchasing April ethanol futures at $1.90 per gallon.
Because the standard heating oil contract covers 42,000 gallons, the speculator has to purchase 35.71 contracts at this scenario. However, partial contracts aren't traded. The following figures are approximate, to make demonstrating this scenario easier:
Date Spot Market Futures Market Basis
Mar 1, $1.88 per gal. Sell in April at $1.98 per gal. -$0.10
Apr 1, $1.85 per gal. Buy in April at $1.90 per gal. -$0.05
The hedge result is as follows:
The gain on the futures trades is $.08 per gallon, with the sell in April at $1.98 per gallon, and the buy in April at $1.90 per gallon. $1.90 minus $1.98 equals $.08 per gallon.
The net sales price is $1.93 per gallon, or $1.85 plus $.08.
This results in 50% being hedged at $1.93 per gallon, with an April income of $2,895,000, or $1.93 per gallon times 1.5 million gallons. The remaining 50% is unhedged, at $1.85 per gallon; April income is $2,775,000, or $1.85 per gallon times 1.5 million gallons.
The average April sales price is $1.89 per gallon, for an April income of $5,670,000.
Without hedging, what would have been with the result? The seller would have received $5,550,000, or $1.85 per gallon times three million gallons. By hedging between the spot and futures markets, there was a net increase in April heating oil income of $120,000. Therefore, hedging cannot only help to protect traders from losses, but it can also increase profits.