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:
- In a typical year, Carey plants 2,000 acres of corn with a yield of roughly 135 bushels per acre.
- During planting season, Carey sells 33 contracts of September corn futures (ZC) on the Chicago Mercantile Exchange (CME).
- 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.
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.