The short hedge is a hedging strategy used by manufacturers and producers to lock in the price of a product or commodity to be delivered some time in the future. Hence, the short hedge is also known as output hedge.
The short hedge involves taking up a short futures position while owning the underlying product or commodity to be delivered. Should the underlying commodity price fall, the gain in the value of the short futures position will be able to offset the drop in revenue from the sale of the underlying.
In March, a wheat farmer is planning to plant 100000 bushels of wheat, which will be ready for harvesting by late August and delivery in September. The farmer knows from past years that the total cost of planting and harvesting the crops is about $6.30 per bushel.
At that time, September Wheat futures are trading at $6.70 per bushel, and the wheat farmer wishes to lock in this selling price. To do this, he enters a short hedge by selling some September Wheat futures.
With each Wheat futures contract covering 5000 bushels, he will need to sell 20 futures contracts to hedge his projected 100000 bushels production.
By mid-August, his wheat crops are ready for harvesting. However, the price of wheat have since fallen and at the local elevator, the price has dropped to $6.20 per bushel. Correspondingly, prices of September Wheat futures have also fallen and are now trading at $6.33 per bushel.
Selling his harvest of 100000 bushels of wheat at the local elevator yields $6.20/bu x 100000 bushels = $620000.
But the cost of growing the crops is $6.30/bu x 100000 bushels = $630000
Hence, his net profit from the farming business = Revenue Yield - Cost of Growing Crops = $620000 - $630000 = -$10000
For all his efforts, the wheat farmer might have ended up with a loss of $10000.
Fortunately, he had hedge his output with a short position in September Wheat futures which have since gained in value.
Value of Wheat futures Sold in March = $6.70 x 20 contracts x 5000 bushels = $670000
Value of Wheat futures Purchased in August = $6.33 x 20 contracts x 5000 bushels = $633000
Net Gain in Futures Market = $670000 - $633000 = $37000
Overall profit = Gain in Futures Market - Loss in Cash Market = $37000 - $10000 = $27000
Hence, with the short hedge in place, the farmer can still manage to make a profit of $27000 despite falling Wheat prices.
The short hedge is not perfect. In the above example, while cash prices have fallen by $0.40/bu, futures prices have only dropped by $0.37/bu and so the short futures position have only managed to offset 92.5% of the drop in price. This is due to the weakening of the basis.
|Net||-$0.40/bu||+$0.37/bu||-$0.03 (Weakened by $0.03)|
The basis tracks the relationship between the cash market and the futures market. Hedgers should pay attention to the basis when deciding when to enter the hedge as they are said to have taken up a position in the basis once a hedge is in place. See basis.
Your new trading account is immediately funded with $5,000 of virtual money which you can use to test out your trading strategies using OptionHouse's virtual trading platform without risking hard-earned money.
Once you start trading for real, your first 100 trades will be commission-free! (Make sure you click thru the link below and quote the promo code '60FREE' during sign-up)Click here to open a trading account at OptionsHouse.com now!
Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results....[Read on...]
If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount....[Read on...]
If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®.... [Read on...]
Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date....[Read on...]
As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative....[Read on...]
Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date....[Read on...]
To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin....[Read on...]
Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading.... [Read on...]
Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator.... [Read on...]
Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa.... [Read on...]
In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as "the greeks".... [Read on...]
Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow.... [Read on...]