What is Hedging?
Futures contracts have been used to manage cash market price risk for more than a century in the United States. Hedging allows a market participant to lock in prices and margins in advance and reduces the potential for unanticipated loss.
Hedging reduces exposure to price risk by shifting that risk to those with opposite risk profiles or to investors who are willing to accept the risk in exchange for profit opportunity. Hedging with futures eliminates the risk of fluctuating prices, but also means limiting the opportunity for future profits should prices move favorably.
A hedge involves establishing a position in the futures or options market that is equal and opposite to a position at risk in the physical market. For instance, a crude oil producer who holds (is “long”) 1,000 barrels of crude can hedge by selling (going “short”) one crude oil futures contract. The principle behind establishing equal and opposite positions in the cash and futures or options markets is that a loss in one market should be offset by a gain in the other market.
Hedges work because cash prices and futures prices tend to move in tandem, converging as each delivery month contract reaches expiration. Even though the difference between the cash and futures prices may widen or narrow as cash and futures prices fluctuate independently, the risk of an adverse change in this relationship (known as basis risk) is generally much less than the risk of going unhedged, and the larger a group of participants in the market, the greater the likelihood that the futures price will reflect widely held industry consensus on the value of the commodity.
Because futures are traded on exchanges that are anonymous public auctions with prices displayed for all to see, the markets perform the important function of price discovery. The prices displayed on the trading floor of the Exchange, and disseminated to information vendors and news services worldwide, reflect the marketplace’s collective valuation of what buyers are willing to pay and what sellers are willing to accept.
The purpose of a hedge is to avoid the risk of adverse market moves resulting in major losses. Because the cash and futures markets do not have a perfect relationship, there is no such thing as a perfect hedge, so there will almost always be some profit or loss. However, an imperfect hedge can be a much better alternative than no hedge at all in a potentially volatile market.
Please be advised that trading futures and options involves substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future results.
To read more about Futures and Options, click here.