Long Hedge & Short Hedge

Hedging can be performed by using different derivatives. The first method is by using futures. Both producers and end-users can use futures to protect themselves against adverse price movements. They offset their price risk by obtaining a futures contract on a futures exchange, hereby securing themselves of a pre-determined price for their product.

An important factor in determining the eventual price, is the basis. The basis is calculated by deducting the futures price form the spot price. By successfully predicting the basis of a commodity, the eventual price of a commodity can be calculated at the moment the hedge is placed.

Long Hedge

End-users take a long position when they are hedging their price risks. By buying a futures contract, they agree to buy a commodity at some point in the future. These contracts are rarely executed, but are mostly offset before their maturity date. Offsetting a position is done by obtaining an equal opposite on the futures market on your current futures position. The profit or loss made on this transaction is then settled with the spot price, where the producer will buy his commodity.

A long hedge refers to a futures position that is entered into for the purpose of price stability on a purchase. Long hedges are often used by manufacturers and processors to remove price volatility from the purchase of required inputs. These input-dependent companies know they will require materials several times a year, so they enter futures positions to stabilize the purchase price throughout the year.

For this reason, a long hedge may also be referred to as an input hedge, a buyer’s hedge, a buy hedge, a purchaser’s hedge, or a purchasing hedge.

A long hedge represents a smart cost control strategy for a company that knows it needs to purchase a commodity in the future and wants to lock in the purchase price. The hedge itself is quite simple, with the purchaser of a commodity simply entering a long futures position. A long position means the buyer of the commodity is making a bet that the price of the commodity will rise in the future. If the good rises in price, the profit from the futures position helps to offset the greater cost of the commodity.

Futures price – Basis + broker commission = Net Purchasing price

Short Hedge

Producers of commodities take a short position when hedging their price risks. They sell their product using a futures contract, for a delivery somewhere later in the future. They hedge their price risk similar to long hedgers. They sell a futures contract, which they offset come the maturity date by buying an equal futures contract. The profit or loss made by offsetting the position is then settled with the price obtained at the spot market. This will be the actual price the producer has obtained for selling their product. Just like a long hedge, the prediction of the basis is a crucial factor for determining the price a producer will receive before hedging the commodity. This price can be calculated using the following formula

Futures price + basis – broker commission = net selling price

A short hedge is an investment strategy used to protect (hedge) against the risk of a declining asset price in the future. Companies typically use the strategy to mitigate risk on assets they produce and/or sell. A short hedge involves shorting an asset or using a derivative contract that hedges against potential losses in an owned investment by selling at a specified price.

A short hedge can be used to protect against losses and potentially earn a profit in the future. Agriculture businesses may use a short hedge, where “anticipatory hedging” is often prevalent.

Anticipatory hedging facilitates long and short contracts in the agriculture market. Entities producing a commodity can hedge by taking a short position. Firms in need of the commodity to manufacture a product will seek to take a long position.

Companies use anticipatory hedging strategies to manage their inventory prudently. Entities may also seek to add additional profit through anticipatory hedging. In a short-hedged position, the entity is seeking to sell a commodity in the future at a specified price. The firm seeking to buy the commodity takes the opposite position on the contract known as the long-hedged position. Companies use a short hedge in many commodity markets, including copper, silver, gold, oil, natural gas, corn, and wheat.

Commodity Price Hedging

Commodity producers can seek to lock in a preferred rate of sale in the future by taking a short position. In this case, a company enters into a derivative contract to sell a commodity at a specified price in the future. The company then determines the derivative contract price at which they seek to sell and the specific contract terms. The company typically monitors this position throughout the holding period for daily requirements.

A producer can use a forward hedge to lock in the current market price of the commodity that they are producing, by selling a forward or futures contract today, in order to negate price fluctuations that may occur between today and when the product is harvested or sold. At the time of sale, the hedger would close out their short position by buying back the forward or futures contract while selling their physical good.

• A short hedge protects investors or traders against price declines.
• It is a trading strategy that takes a short position in an asset where the investor or trader is already long.
• Commodity producers can similarly use a short hedge to lock in a known selling price today so that future price fluctuations will not matter for their operations.

Long Hedges vs. Short Hedges

Basis risk makes it very difficult to offset all pricing risk, but a high hedge ratio on a long hedge will remove a lot of it. The opposite of a long hedge is a short hedge, which protects the seller of a commodity or asset by locking in the sale price.

Hedges, both long and short, can be thought of as a form of insurance. There is a cost to setting them up, but they can save a company a large amount in an adverse situation.