Hedging is a major factor in the investment world, especially when it comes to commodities. Commodity exchanges are made up mostly of speculators, and hedgers. The purpose of speculators is to take risks, and make money from it, it is quite the opposite for hedgers. Hedgers are in the market in order to mitigate their potential losses. Although commodities exchanges are mainly existing for hedgers to use, there are currently more speculators than hedgers. Below you can see a very simplified representation of hedging, and speculating in the commodities market, and the roles they play;
What is Hedging?
A hedge is an investment strategy used in order to reduce the risk of price movements in a given asset. Generally, in order to hedge, an opposite or offsetting position is taken in the given asset.
Hedging can be considered as an insurance policy. Essentially, it is a way to protect yourself so when something out of your control happens, you are not affected by it or the extent of its effects are decreased. Trades may not pan out as one plans but you can take hedging positions ahead of time in order to mitigate your potential losses.
The main hedging strategies are through derivatives. Derivatives are securities that move in correspondence to their underlying assets. Derivatives can be futures, forwards, swaps or options contracts with underlying assets that may be commodities, stocks, currencies, bonds, interest rates and indices. Below is a graph showing how a hedging strategy works out, in this case, it is concerning positions on physical oil. The hedger has a long position on oil and in order to not be affected by the price changes in the future, they are short on an oil future contract. In this case, the hedge provides a stable outcome concerning the money that comes out of their pocket. At any given price in the future, they do not make any profit but more importantly they do not have any losses from it.
It is true that hedging strategies mitigate your losses however it behaves the same way with your gains. Because it is basically two different positions taken on the same asset or its derivatives. The two opposite positions can be weighted differently in order to favor one side or another however there will still be limitations to your gains with hedging strategies.
One simple example can be given from the metals industry. An iron production company is planning to have 10’000kg of iron ready to be sold in 6 months. However, they are not sure what the price will be at that time in the future. In order to hedge against this uncertainty of potential losses, they sell iron futures. This way, they will have locked in a price for when their product is ready to be shipped to the customer. This goes both ways, a demander of the market requires 10’000kg of iron in 6 months, thus, they can enter a futures contract and ensure the price that they will buy iron 6 months later. At the end, there is a guarantee of sale in the future at a set price.
This strategy can be used in many different commodity industries. In agriculture, seeds are planted months in advance and farmers can hedge against the potential decrease in price of the given product until the harvest. If the price of a is currently 780 USD/bushel, the farmer can sell a futures contract at 760USD/bushel assuming that is a satisfying price for them. Another example is from the energy commodities as airlines, especially after the 2008 crisis, hedge against fuel as they buy in large quantities and the slightest changes in price can cause a significant unexpected loss.
What are the different types of hedging?
We talked about using derivatives to hedge against the price fluctuations and potential losses. However, that is not the only way. Diversification is also a very beneficial strategy. Diversifying your portfolio is a great way to decrease the effects of potential fluctuations on your holdings. For example, Gold is a very stable asset to have, as history has showed us, and it is a great option if you are looking to hedge against the US Dollar and many other currencies. Other than gold, industrial metals, agricultural products, oil and gas are all commodities that depend on different factors concerning their prices.
Aside from futures, forward contracts can also be used. The downside of forwards is that they are not regulated and do not have the support of clearing houses. Clearing houses are the institutions that make sure parties have the funds to go through with the deal when the time comes. With forwards, you enter a contract but there is no entity to guarantee the other party is able to pay for the settlement.
What is the best hedging strategy in Commodities Trading?
The best hedging strategy does exist but it depends heavily on your expectations from it. Whether you are a hedger or a speculator or what the commodity that you are interested in.
Hedging in agricultural commodities make up a major slice of the pie. And it is vital to use it as we are currently witnessing extremely unprecedented markets. As mentioned before, farmers can hedge with futures contracts. However, as some wait until it’s too late and lose out. June and July are important for the price forecast due to threats of weather and as farmers wait too much on those forecasts, they lose out on the opportunity to mitigate their losses.
Before hedging, one must understand the purpose of it. If you are a hedger and not a speculator, the reason you open that position, is to mitigate your losses. Waiting for a better deal and risking the current one, makes you a speculator.
Nearly all hedging practices have their downsides. Just like any and all trades, it does not guarantee success nor the mitigation of all losses. The hedger must make sure to weight out the pros and cons such as the added expense of the new position.
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References
- EnHelix. (n.d.). Commodity Hedging: Basic Facts You Should Know | EnHelix. https://www.enhelix.com/what-is/commodity-hedging/
- Kowalski, C. (2021, March 4). Hedging and How it Works in the Commodity Market. The Balance. https://www.thebalance.com/hedging-in-commodities-809379
- Reiff, N. (2021, September 30). Hedge. Investopedia. https://www.investopedia.com/terms/h/hedge.asp
- ReneSource Capital. (n.d.). Hedging and Risk management — Renesource Capital. http://Www.renesource.com. https://www.renesource.com/en/services/hedging-and-risk-management
