Futures Trading 101: What Does Hedging Mean?
So what exactly does it mean to hedge? First, there was Sonic the Hedgehog who repeatedly failed to defeat Dr. Robotnik. Then along came unregulated private funds like Long Term Capital Management which obviously didn’t live up to it’s name sake. Then there’s futures trading, where a career can be made by taking the other side of speculator’s trade. But how does it work? For all of you chimps out there, check out this infographic from Partnership For A Secure Financial Future on how hedging works...
HEDGE: an investment that is used in an attempt to reduce the risk of adverse price movements in an asset.
THE UNDERLYING
In this example, we use a farmer who investments their money into wheat to sell for a profit. However, there is risk involved such as drought, excess supply, flood, spoilage, etc. But it could just as easily be the same for purchasing a Dow 100 future in which the risk would be economic, fear, greed, geopolitical, or political. Just insert any investment that has risk and hedging can be used to minimize it.
BUYER-SELLER CONTRACT
The farmer determines their profit margin but is kept in-check by the baker. If priced too high, the baker will go to market for the lowest cost. If priced too low, the farmer will operate at a loss. It’s probable that both will use a naive forecast and adjust accordingly once the wheat is harvested.
MARKET PRICING
The farmer and baker set a price for a future date irrespective of the market. The contract involves a particular commodity which details the quantity and quality of the asset and are settled in either cash or physical delivery. If there is excess demand and the market price is higher, the baker benefits. However, if there’s excess supply then the farmer benefits instead of losing at market prices.
For more details, see the contract specifications here.
Stay tuned for next week’s post where I share another infographic, What Is A Speculator?
Questions, comments, or concerns? Put it below.
what I'll never understand is how hedging is used in context with a farmer out in bumblef**k Idaho or something, who is going to 'hedge' his crop output?
I lost at the sonic part
but seriously, this was helpful
Let's say I'm a corn farmer in Iowa. Once I have a pretty idea of how much corn I'm going to produce this year, I enter a futures contract with someone at a price on the board; it could be a speculator or could be an entity such as ADM or Tyson Foods that actually will put the corn to use (the speculator on the other hand would probably just sell the contract because he doesn't actually want corn delivered to him). Note that soft commodity liquidity varies and is usually highest for contracts right after the harvest period (e.g. Nov contract for soybeans, Dec contract for corn).
Why do I want to hedge rather than just sell at spot price after harvest? Well because farmers by nature are very conservative. For them, $5/bushel guaranteed (granted, there's always counterparty risk) is good enough, especially when it costs $2/bushel to produce the corn. Why take the chance of corn prices dropping through the season even if there's a chance they go up to $7? ADM or Tyson are hedging on the other side in order to be able to stabilize margins. Keep in mind they're hedging on the other side as well (e.g. Tyson may sell forward Lean Hogs meat).
Hopefully this helps answer your Q. Hedging is used by farmers the same way it's used by corporations: To control risk. Unlike speculators, these farmers are entering "real" contracts where they have to actually deliver good to the counterparty at contract expiration.
edit: Just wanted to add that a lot of farmers will only hedge part of their crop and sell the rest at spot once harvest is complete.
i really enjoy the latest craze to use info graphics!
What do traders refer to when they say they have to "hedge their deltas" or hedging in general? How do they reduce their risk when trading normal securities and can someone provide a real example of one?
Thanks!
Delta hedging has more to do with call/put option derivatives than with futures.
Delta is the sensitivity of the price of a call/put option to a change in price of the underlying security - e.g. how much will the price of a call option on AAPL change if the stock goes up or down 1%. To go delta neutral (i.e. 100% delta heding), you figure out the delta and then buy that many offsetting options per underlying stock to completely hedge a long/short position.
This video tutorial does a good job of explaining:
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