Commodity hedging is when an individual or company kickoffs the risks originating due to fluctuations in prices of raw-materials. When people hedge, they are actually ascertaining their investment against unforeseen events. This process is kind of an insurance method for traders, farmers, and producers to protect themselves against negative price fluctuations.
Hedging does not assure profits but helps in preventing or minimizing the possible losses at a future date. Most commodity traders, retail investors, companies, as well as governments make use of hedging in order to minimize the risk exposure.
How Does It Work?
Since the prices of commodities rise and fall constantly, traders cover themselves against the risk of upcoming fluctuations. For this reason, they buy or sell positions in the futures markets.
Say for instance, if a manufacturer expects the price of his commodity to rise in the next couple of months, he will buy a position at the prevailing rates to deal with the probable price rise. Similarly, if the prices are expected to fall, he sells them in the futures market at present rates against the actual goods he holds. When planning to hedge, it is; therefore, better to estimate at what rate you would like to hedge and the time for it.
Short Hedging & Long Hedging
Hedge investors have two basic alternatives - to either go short or go long. But, some may use strategies that involve both. 'Long hedging’ means buying early so as to sell later at a higher price. ‘Short Hedging’ means selling before one buys thereby expecting the futures price to decline.
Let us understand this with an example. If a farmer expects the sugar prices to fall from Rs 80/kg to Rs 70/kg, he sells the positions in the futures market at the current price i.e. Rs 80/kg. So, even if the price falls, as expected, he will still get the benefit of Rs 80/kg as per the contract. This act of selling positions in order to prevent the risk of a loss is called ‘short hedging’.
On the other hand, if a farmer anticipates that the current price of wheat will go up in near future, he buys a position in the futures market at current price. So, even if the price goes up say for instance from Rs 50/kg to Rs 54/kg in the next month, he will benefit buying at the price of Rs 50/kg from the seller as per the contract. This act of buying positions to prevent upside risk is called ‘long hedging’.
Can Hedging be Risky?
Hedging, generally isn’t considered risky if it takes care of short-term requirements. However, if an individual anticipates or spots a wrong bet, then he is likely to put himself at risk.
Most often, people don’t hedge until the last minute. They don’t react until commodity prices have increased to such an extent that the people are unable to effectively hedge risk based on their own calculation. Had they been hedging the right way, they could have avoided the possible losses.
To know more about how commodities market works and how trading in commodity market is done click here.