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