Hedging Strategies with Futures

Introduction 

Facing ongoing market volatility, Theodore explores hedging strategies to protect his company's financial stability. 

Hedging with futures is a risk management approach to offset potential losses from price fluctuations in commodities or financial instruments. 

Participants can lock in prices and secure profit margins by taking an opposite position in the futures market relative to physical market exposure. 

This strategy aims to reduce the risk of adverse price changes, ensuring business continuity.

Short Hedging Techniques 

Short hedging involves selling futures contracts to protect against potential price declines in an asset you own or plan to sell. 

This strategy is used by producers or sellers of commodities who risk revenue loss if market prices drop. 

For example, a farmer expecting to harvest wheat in the future can sell wheat futures now, locking in the current price. 

If the market price falls at harvest, the gain from the futures position offsets the loss from selling the crop at a lower price, stabilizing income.

Long Hedging Explained 

Long hedging entails buying futures contracts to protect against rising prices of a commodity or asset you plan to purchase. 

This technique is employed by buyers or consumers who face increased costs if market prices rise. 

Manufacturers needing raw materials, like metals or energy resources, use long hedges to secure current prices for future needs. 

By purchasing futures contracts, they lock in costs, ensuring that price increases won't adversely affect their profit margins or budgeting plans.

Theodore Implements Long Hedging 

Anticipating the need for 1,000 tons of steel in six months, Theodore buys futures contracts at $600 per ton, totaling $600,000. 

When steel prices rise to $650 at delivery, buying on the spot market would cost $650,000, a $50,000 increase. 

However, his futures contracts have gained $50 per ton, providing a $50,000 profit. 

This offsets the higher spot price, effectively keeping his steel cost at $600 per ton. 

By implementing this long hedge, Theodore secures stable costs and protects profit margins.