Physical Trading and Hedging Question

Hello physical traders,

I have a couple questions regarding hedging:

1) Are all cash moves hedged immediately? I would assume it would be different depending on the size of the merchant firm, but in general, do physical traders immediately hedge price risk, or is there an element of speculation by delaying when or if it gets hedged?

2) It seems that futures are widely regarded as the main method of hedging. Why are options and swaps secondary to futures? Is it because of the ease at which you can take the opposite position? I ask because in crazy market swings, wouldn't futures be subject to margin call risk?

I apologize if the questions are basic. I am a recent college grad who is looking to get more info about the physical space!

Thanks!

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Comments (11)

Apr 30, 2019 - 10:33pm

I'll take a shot at these.

1) No -not every cash trade is hedged immediately. It could vary based on the following:
- time of trade (are the mkts even open to hedge - or are you taking on flat price risk by trading overnight?)
- view on the mkt - if you see futures moving in a direction that helps you out maybe you hedge only part of it and take a position
- firm policies, risk tolerance and experience. (this might be the biggest reason as to why you would or wouldn't take on flat price risk and the amount that you can take on)
- how you sold it or bot it. Did you buy/sell basis or flat price? This will affect how you hedge or what you want to hedge.
- Does the commodity you trade have a liquid pit where you can hedge futures against? This is not always the case.

2)
- this is a great question. Agreed that i mainly see futures as the mechanisms used to hedge with. Maybe someone else can chime in here as to why this is. I don't have alot of experience in options and swaps but here's my thoughts:
- its the way things have always been done. (yes this isn't a great answer but try telling that to old school commodity traders who don't care about options). They are used to futures and understand the intricacies how they work, their relation to the cash/physical mkt, and the delivery mechanisms specific to that commodity.

Most Helpful
May 1, 2019 - 10:06am

Option structures are more difficult to get in and out of - its more of a put it on and let it ride. Additionally, you have exposure associated with pricing with a lot of structures that do not match your volume in the sense that you may try to reduce some cost on a structure by selling something that gives you exposure as you approach a price point.

Lastly, and this is most important, if you have the balance sheet, why pay a premium for the same risk? If you can afford to have the margin requirements met at a certain point, why not just take the outright flat price risk and not pay the time value of the premium as well?

  • 4
May 1, 2019 - 12:31pm
  1. If you trade a physical position, you should be assuming its hedged immediately and only looking at the basis. The basis risk should be thought of independently from your prop futures position, which is usually in a separate book. Most firms have a separate hedge desk/trader who will give you a level for the futures. Sometimes they may hedge it immediately, or choose to hold the risk, but it's a slippery slope to be blending cash and prop positions as someone could easily bury losses on a cash book to boost their prop pnl

  2. Margin call risk isn't that big of a deal, handled at firm wide level. If at a big shop with billions in credit lines it only matters in times of crisis like 2008

  • It doesn't make sense to be thinking about hedging a specific physical trade with a specific option

Should be thought of independently as
1. basis position where you assume everything phsyical is hedged with futures (risk is the value of the physical vs spread to the future)
2.Outright Directional exposure
3. Spreads exposure
4. Options exposure (greeks)

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May 1, 2019 - 2:53pm

To add on to your 1) all physical trading is arbitrage really. You have arb windows that are open or closed and when they are open its relative to a futures market price. You can have a spread or a physical asset that allows you to capture that arb window, which can give you opportunities to trade around something, but in general you are locking in the use of an asset in the money in the future. Its usually best to hedge that right away in the most efficient way possible.

  • 1
May 2, 2019 - 2:05pm

Ahhhhh, so you're looking at the firms positions as a whole to see if a hedge is necessary and for the trader, they focus on trying to create the largest basis spread possible for each physical transaction? Whether that be by selling first in a downward trending market or buying first in an upward.

And I mention the question about margin call risk because my father owned a cotton shop that got hit in '08 and '11. Just trying to understand risk and risk protection.

May 9, 2019 - 12:45pm

1) For me, not all physical purchases are hedged immediately. It can depend on overall position and market outlook. Also as an exporter we do not always need to hedge with futures and can reduce risk by immediately making sales against purchases. We can also take a position buying on basis from a farmer where they are not actually using any futures themselves and we are in control of the hedging. Ex. Farmer has a target price of $8.50/bu for soybeans delivered to a river loading point. The farmer sold to us at a $.60 under basis delivered so he has a target price of $9.10 on the futures. We could take a spec position and create better a better basis level if we think the market is going to rally further so instead we have orders in to sell futures at $9.20+.

2) I use some options to delta hedge physical purchases but the issue with this is liquidity and you can sometimes struggle to get out of positions.

May 10, 2019 - 10:53am

Also there are markets where the hedging is completely based on swap due to a lack to futures. A lot of swaps have been termed as "futures" just to be clear of regulation. Eg: Naphtha in Europe is hedged with NEC "Futures"

However look into its mechanism and you'll find its clearly a swap.

  • 1
May 10, 2019 - 11:24am

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