In the business world, “risk” is often the nastiest four-letter word in the book. As a result, finding effective hedging techniques to protect asset values and profitability is a common pursuit for people in a wide variety of industries.
Due to their inherent flexibility, futures products are especially useful for hedging. The applications of futures in risk management are extensive, limited only by the imagination of the individual. Regardless of your position in the market or business world, futures hedging techniques can help you limit risks — both foreseeable and obscure.
Three Futures Hedging Techniques
When it comes right down to it, if you’re interested in hedging you’re either a consumer, producer, or investor. It’s important to remember that each of these roles is not mutually exclusive of the others and that all feature a collection of unique risks. Futures can be a great help when addressing your exposure, regardless of perspective.
#1 Producer Hedging
Of all of the futures hedging techniques examined in this article, those used to address producer risk are the most intuitive. Farmers and ranchers frequently implement strategies designed to mitigate the negative impacts of harsh weather or global geopolitics on asset pricing. This is a common practice among commodities producers for good reason ― an untimely market fundamental can destroy a year’s worth of work.
Managing the risk facing an upcoming delivery to market may be accomplished in many ways. One simple strategy using futures is to take an offsetting short position in the commodity to be delivered. For example, assume that Iowa corn farmer Morgan is anxious over the prospects of an industry-wide bumper crop swamping the markets with supply. To insulate against falling corn prices come harvest time in October, Morgan turns to the futures markets:
- Given a yield of 130 bushels per acre, Morgan sells 13 September corn futures contracts (ZC) for every 500 planted acres. The position is taken shortly after planting in mid-April.
If the corn market weakens as Morgan predicts, losses in the cash markets are offset by gains realized from the short futures position.
#2 Consumer Hedging
From the standpoint of the consumer, risk is assigned according to the pending acquisition of assets. If you’re planning to purchase the raw materials you need to conduct business, then the pricing of those items is of paramount importance. Many businesses, both large and small, typically use futures hedging techniques within the framework of a comprehensive risk management plan.
For instance, let’s assume that Hayden Wire Inc. is in search of protection from a late-year spike in metals pricing. Rising copper prices may force a scaling-back of production and crush the company’s profitability for the coming year. The futures markets can help Hayden limit risk via the following strategy:
- Hayden Inc. purchases 20 December copper futures contracts (HG) to cover exposure to the 500,000 pounds of raw copper needed for the coming quarter’s workload.
In the event prices spike, the added cost to secure the needed copper is largely offset by gains realized from the long futures position. If prices fall, losses from the long position are mitigated by the affordability of the physical asset.
#3 Investor Hedging
While the hedging techniques for producers and consumers involve straightforward buying and selling, managing investment risk is a more nuanced subject. One basic way that futures are used to hedge investment risk is in the arena of equities. As an example, assume that Avery the stock picker anticipates a U.S. equities bull market developing during the coming summer months. Subsequently, Avery takes a large long position in the S&P 500 to capitalize on the action. Futures can be used as protection against negative market drivers in the following manner:
- Avery sells 15 September E-mini S&P 500 futures contracts to limit portfolio exposure to any detrimental swings in seasonal equities pricing.
If an unforeseen event occurs that drives the value of U.S. stocks lower, Avery’s long position in the S&P 500 is protected. Gains will be realized from the short position in the E-mini S&P 500, at least minimizing the damage sustained by the outstanding cash position.
Avoid Catastrophe with Hedging
Although the strategies outlined in this blog certainly reduce risk exposure, there’s no perfect hedge. A risk of loss is involved in every facet of finance ― hedging is simply a way to put it into acceptable terms.