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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 division of StoneX Financial Inc. located in the heart of Chicago’s financial district. Established by renowned commodity trader Andy Daniels in 1995, Daniels Trading was built on a culture of trust committed to a mission of Independence, Objectivity and Reliability.

Risk Disclosure

The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.

Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.

© 2023 StoneX Group Inc. All Rights Reserved

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Risk Disclosure

The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.

Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.

© 2023 StoneX Group Inc. All Rights Reserved

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