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Risk Management 101: What Is Hedging?

January 29, 2020 by Daniels Trading| Ag Marketing

In the real world, as well as in the markets, managing risk is a critical part of avoiding financial catastrophe. From buying a life insurance policy to diversifying your portfolio, actively addressing risk can save countless dollars and provide peace of mind.

For producers, traders, and investors, the question of “What is hedging?” is one worth asking. When you examine the relevant “hows” and “whys” of hedging, capitalizing upon its many benefits quickly becomes possible.

What Is Hedging?

By definition, a “hedge” is the act of using one investment or trade to reduce the risk of another. There are many ways to accomplish this objective, including the buying or selling of futures, options, equities, and currency products. In the same fashion as a life insurance policy provides financial security, a solid hedge insulates wealth or market share from undue risk exposure.

To further address the question of “What is hedging,” let’s assume that Carey the Iowa corn farmer is interested in taking the guesswork out of this year’s harvest. Uncertainties persist for the marketing year, particularly related to an expected El Niño cycle and export tariffs. Subsequently, a surplus of corn may drive prices south come harvest time.

To limit the negative financial impact of such a scenario, Carey decides to use corn futures to hedge against the unknown:

  1. In a typical year, Carey plants 2,000 acres of corn with a yield of roughly 135 bushels per acre.
  2. During planting season, Carey sells 33 contracts of September corn futures (ZC) on the Chicago Mercantile Exchange (CME).
  3. At 5,000 bushels per contract, the new short position in September corn offers downside price protection for 60 percent of Carey’s expected crop yield.

In the event that corn prices fall at harvest time, the short corn futures position will generate profits. Although the gains realized will not outweigh the adverse impacts of subpar pricing, they will help to limit losses. In addition, other alternatives, including storage, may become more attractive.
Download our free guide, The Ultimate Guide to Hedging: How to Reduce Risk, today!

The Benefits of Hedging

In practice, the answer to what is hedging is different for different people. For producers like Carey, locking in profits from the marketing of a tangible good or service is typically the primary objective. For active traders and investors, mitigating the systemic risk exposure of an open position is the paramount goal. Further, institutions such as banks and governments regularly look for ways to manage their currency risk on a large scale.

For anyone who puts capital in harm’s way with the hope of financial reward, hedging is a discipline worth investigating. Here are three of its primary benefits:

  • Avoid disaster: A strong hedge provides insurance against risks known and unknown. By hedging, you can effectively limit the possibility of unforeseen events bringing financial catastrophe.
  • Consistent bottom line: Hedging strategies may be used to bring long-term stability to P&L. Producers typically implement such plans to lock in profits from operations, as do investors looking to achieve steady rates of return.
  • Gain peace of mind: The psychological impact of assuming undue or excessive risk can be extreme. By implementing a sound hedging strategy, you can eliminate a great deal of stress.

Often, the road to riches is littered with failure. Nonetheless, through gaining an understanding of what hedging is, you can successfully navigate many financial pitfalls.

How Can Hedging Improve Your Financial Game Plan?

When it comes to hedging, one size doesn’t fit all. Depending on your resources, strategies, and objectives, your risk profile will vary. A simple chat with an industry professional is a great way to learn about how to manage your unique exposure.

For more information on the ins and outs of hedging, schedule your free one-on-one consultation with a member of the Daniels Trading team today.

The Ultimate Guide to Hedging: How to Reduce Risk

Filed Under: Ag Marketing

About Daniels Trading

Daniels Trading is an independent futures brokerage firm located in the heart of Chicago’s financial district. Established by renowned commodity trader Andy Daniels in 1995, Daniels Trading is built on a culture of trust committed to the firm’s mission of Independence, Objectivity and Reliability.

Risk Disclosure

THIS MATERIAL IS CONVEYED AS A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION.

THIS MATERIAL HAS BEEN PREPARED BY A DANIELS TRADING BROKER WHO PROVIDES RESEARCH MARKET COMMENTARY AND TRADE RECOMMENDATIONS AS PART OF HIS OR HER SOLICITATION FOR ACCOUNTS AND SOLICITATION FOR TRADES; HOWEVER, DANIELS TRADING DOES NOT MAINTAIN A RESEARCH DEPARTMENT AS DEFINED IN CFTC RULE 1.71. DANIELS TRADING, ITS PRINCIPALS, BROKERS AND EMPLOYEES MAY TRADE IN DERIVATIVES FOR THEIR OWN ACCOUNTS OR FOR THE ACCOUNTS OF OTHERS. DUE TO VARIOUS FACTORS (SUCH AS RISK TOLERANCE, MARGIN REQUIREMENTS, TRADING OBJECTIVES, SHORT TERM VS. LONG TERM STRATEGIES, TECHNICAL VS. FUNDAMENTAL MARKET ANALYSIS, AND OTHER FACTORS) SUCH TRADING MAY RESULT IN THE INITIATION OR LIQUIDATION OF POSITIONS THAT ARE DIFFERENT FROM OR CONTRARY TO THE OPINIONS AND RECOMMENDATIONS CONTAINED THEREIN.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. THE RISK OF LOSS IN TRADING FUTURES CONTRACTS OR COMMODITY OPTIONS CAN BE SUBSTANTIAL, AND THEREFORE INVESTORS SHOULD UNDERSTAND THE RISKS INVOLVED IN TAKING LEVERAGED POSITIONS AND MUST ASSUME RESPONSIBILITY FOR THE RISKS ASSOCIATED WITH SUCH INVESTMENTS AND FOR THEIR RESULTS.

TRADE RECOMMENDATIONS AND PROFIT/LOSS CALCULATIONS MAY NOT INCLUDE COMMISSIONS AND FEES. PLEASE CONSULT YOUR BROKER FOR DETAILS BASED ON YOUR TRADING ARRANGEMENT AND COMMISSION SETUP.

YOU SHOULD CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR CIRCUMSTANCES AND FINANCIAL RESOURCES. YOU SHOULD READ THE "RISK DISCLOSURE" WEBPAGE ACCESSED AT WWW.DANIELSTRADING.COM AT THE BOTTOM OF THE HOMEPAGE. DANIELS TRADING IS NOT AFFILIATED WITH NOR DOES IT ENDORSE ANY TRADING SYSTEM, NEWSLETTER OR OTHER SIMILAR SERVICE. DANIELS TRADING DOES NOT GUARANTEE OR VERIFY ANY PERFORMANCE CLAIMS MADE BY SUCH SYSTEMS OR SERVICE.

GLOBAL ASSET ADVISORS, LLC (“GAA”) (DBA: DANIELS TRADING, TOP THIRD AG MARKETING AND FUTURES ONLINE) IS AN INTRODUCING BROKER TO GAIN CAPITAL GROUP, LLC (GCG) A FUTURES COMMISSION MERCHANT AND RETAIL FOREIGN EXCHANGE DEALER. GAA AND GCG ARE WHOLLY OWNED SUBSIDIARIES OF STONEX GROUP INC. (NASDAQ:SNEX) THE ULTIMATE PARENT COMPANY.

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Risk Disclosure

THIS MATERIAL IS CONVEYED AS A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION.

THIS MATERIAL HAS BEEN PREPARED BY A DANIELS TRADING BROKER WHO PROVIDES RESEARCH MARKET COMMENTARY AND TRADE RECOMMENDATIONS AS PART OF HIS OR HER SOLICITATION FOR ACCOUNTS AND SOLICITATION FOR TRADES; HOWEVER, DANIELS TRADING DOES NOT MAINTAIN A RESEARCH DEPARTMENT AS DEFINED IN CFTC RULE 1.71. DANIELS TRADING, ITS PRINCIPALS, BROKERS AND EMPLOYEES MAY TRADE IN DERIVATIVES FOR THEIR OWN ACCOUNTS OR FOR THE ACCOUNTS OF OTHERS. DUE TO VARIOUS FACTORS (SUCH AS RISK TOLERANCE, MARGIN REQUIREMENTS, TRADING OBJECTIVES, SHORT TERM VS. LONG TERM STRATEGIES, TECHNICAL VS. FUNDAMENTAL MARKET ANALYSIS, AND OTHER FACTORS) SUCH TRADING MAY RESULT IN THE INITIATION OR LIQUIDATION OF POSITIONS THAT ARE DIFFERENT FROM OR CONTRARY TO THE OPINIONS AND RECOMMENDATIONS CONTAINED THEREIN.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. THE RISK OF LOSS IN TRADING FUTURES CONTRACTS OR COMMODITY OPTIONS CAN BE SUBSTANTIAL, AND THEREFORE INVESTORS SHOULD UNDERSTAND THE RISKS INVOLVED IN TAKING LEVERAGED POSITIONS AND MUST ASSUME RESPONSIBILITY FOR THE RISKS ASSOCIATED WITH SUCH INVESTMENTS AND FOR THEIR RESULTS.

TRADE RECOMMENDATIONS AND PROFIT/LOSS CALCULATIONS MAY NOT INCLUDE COMMISSIONS AND FEES. PLEASE CONSULT YOUR BROKER FOR DETAILS BASED ON YOUR TRADING ARRANGEMENT AND COMMISSION SETUP.

YOU SHOULD CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR CIRCUMSTANCES AND FINANCIAL RESOURCES. YOU SHOULD READ THE "RISK DISCLOSURE" WEBPAGE ACCESSED AT WWW.DANIELSTRADING.COM AT THE BOTTOM OF THE HOMEPAGE. DANIELS TRADING IS NOT AFFILIATED WITH NOR DOES IT ENDORSE ANY TRADING SYSTEM, NEWSLETTER OR OTHER SIMILAR SERVICE. DANIELS TRADING DOES NOT GUARANTEE OR VERIFY ANY PERFORMANCE CLAIMS MADE BY SUCH SYSTEMS OR SERVICE.

GLOBAL ASSET ADVISORS, LLC (“GAA”) (DBA: DANIELS TRADING, TOP THIRD AG MARKETING AND FUTURES ONLINE) IS AN INTRODUCING BROKER TO GAIN CAPITAL GROUP, LLC (GCG) A FUTURES COMMISSION MERCHANT AND RETAIL FOREIGN EXCHANGE DEALER. GAA AND GCG ARE WHOLLY OWNED SUBSIDIARIES OF STONEX GROUP INC. (NASDAQ:SNEX) THE ULTIMATE PARENT COMPANY.

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