producers can hedge against falling price by taking up a position in the futures market.
producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of that is only ready for sale sometime in the future.
To implement the short hedge, producers sell (short) enough futures contracts in the futures market to cover the quantity of to be produced.
Futures Short Hedge Example
A has just entered into a contract to sell 0 s of , to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of on the day of delivery. At the time of signing the agreement, spot price for is 0.0000/ while the price of futures for delivery in 3 months' time is NaN/.
To lock in the selling price at NaN/, the can enter a short position in an appropriate number of futures contracts. With each futures contract covering 0 s of , the will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the will be able to sell the 0 s of at NaN/ for a total amount of NaN. Let's see how this is achieved by looking at scenarios in which the price of makes a significant move either upwards or downwards by delivery date.
Scenario #1: Spot Price Fell by 10% to 0.0000/ on Delivery Date
As per the sales contract, the will have to sell the at only 0.0000/, resulting in a net sales proceeds of 0.0000.
By delivery date, the futures price will have converged with the spot price and will be equal to 0.0000/. As the short futures position was entered at NaN/, it will have gained NaN - 0.0000 = NaN per . With 100 contracts covering a total of 0 s, the total gain from the short futures position is NaN
Together, the gain in the futures market and the amount realised from the sales contract will total NaN + 0.0000 = NaN. This amount is equivalent to selling 0 s of at NaN/.
Scenario #2: Spot Price Rose by 10% to 0.0000/ on Delivery Date
With the increase in price to 0.0000/, the producer will be able to sell the 0 s of for a higher net sales proceeds of 0.0000.
However, as the short futures position was entered at a lower price of NaN/, it will have lost 0.0000 - NaN = NaN per . With 100 contracts covering a total of 0 s of , the total loss from the short futures position is NaN.
In the end, the higher sales proceeds is offset by the loss in the futures market, resulting in a net proceeds of 0.0000 - NaN = NaN. Again, this is the same amount that would be received by selling 0 s of at NaN/.
As can be seen from the above examples, the downside of the short hedge is that the seller would have been better off without the hedge if the price of the commodity went up.
Learn More About Futures & Options Trading
- Futures Basics
- Buying Futures to Profit from a Rise in Prices
- Selling Futures to Profit from a Fall in Prices
- Hedging Against Rising Prices with Futures
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