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This chapter is from the book

A hedging example

The primary thrust of this book is geared toward the speculator and how he can use the commodity futures and options markets to make money. However, it is important for all traders to understand how a typical hedge might work to see why these markets exist in the first place. Remember, the perfect hedge is rare; there is just about always some basis risk. However, the concept is the same regardless of whether we are discussing a packing plant hedging its live cattle needs or a bank hedging its interest rate risk. Hedges come in two basic forms: the short and the long.

The short hedge

A short hedge is entered into to protect the value of an inventory. Consider an example using crude oil. An inventory of 1,000 barrels of crude oil constantly changes in value from wellhead to consumer, even before it is processed into gasoline or heating oil. A short hedge is used by the owner of a commodity to essentially lock in the value of the inventory prior to the transferring of title to a buyer. A decline in prices generates profits in the futures market on the short hedge. These profits are offset by depreciation in the inventory value.

Let's say an oil producer is afraid of a price decline. In August, he anticipates he will sell his August production in September. His production is 1,000 barrels a day for 25 days. The cash price in August is $20 per barrel, and October futures are quoted in August at $20.10 per barrel. Here's what the producer might do in the futures market: sell 25 October futures (each contract is for 1,000 barrels, so this represents his August production of 25,000 barrels) at $20.10, which locks in a value of his inventory equivalent to $502,500 ($20.10 per barrel times 25,000 barrels.) Suppose he is correct about the price falling. Along comes September 15, and the price of crude falls in the cash market by $2 per barrel. Because the futures mirror the cash fairly closely, the futures also fall in price. Let's say the futures on that date are quoted at $18 per barrel. The cash price on September 15 is now $18, or $2 less than the $20 price at production time. He sells his product in the cash market to the refinery for a total of $450,000 ($18 times 25,000), or $50,000 less than what he could have received in August. However, the futures have also dropped, and he buys back his October futures contracts on September 15 for $18. (This offsets his position; he does not have to make delivery.) Remember, he sells for the equivalent of $502,000, he buys back at the equivalent of $450,000, and the difference of $52,000 is his gain in the futures. The futures gain of $52,000 offsets the cash market loss of $50,000, and he has, in effect, protected the value of his inventory at the August price.

What if the oil producer is wrong, and the cash price rises? Let's say that instead of falling to $18, the cash price rises to $21 by September 15, and the October futures rise to $21.10. His 25,000 barrels realize him $525,000 in the cash market, or $25,000 more than he could have received in August. However, his futures also rise to a total value of $527,500 ($21.10 times 25,000). When he buys his contracts back, he realizes a futures loss of $25,500 ($502,000 minus $527,500). Therefore, the futures loss of $25,500 must be taken into consideration with the extra cash profit of $25,000. He still comes back to approximately the August price. The short hedge has protected the value of his inventory at about $20, which is the number he was happy with.

The Nebraska farmer, who wants to lock in the price of his corn for harvest time in the fall, while it is still in the ground during the summer, would use a short hedge in much the same way.

The long hedge

The long hedge is entered into by a commodity user (buyer) to fix acquisition costs and ensure a certain profit margin.

For example, let's suppose an ethanol producer (a corn-based fuel additive) uses 1 million bushels of corn to meet the ethanol requirements for his major customer during the peak summer driving season. It is April, and July corn futures are quoted at $2.50 per bushel. By July, depending on weather, exports, and other unknowns, the price of corn could be much higher or lower. This big customer wishes to enter into a contract with the producer for delivery at today's price in August (for ethanol the producer will manufacture in July). The producer knows he can make a profit at today's ethanol prices if the price of corn remains at $2.50. He calculates his gross profit at $2.50 corn to be $50,000. His profit would be greater if corn prices fell. His break-even is at $2.70 corn, and if corn prices rise above this level, he would actually wipe out his profit margin and see red ink (assuming today's ethanol prices, which also could fluctuate).

To keep his customer happy and loyal and to ensure his plant continues to run at capacity, he enters into an agreement to deliver ethanol at today's price to the big customer in August. Rather than take the risk of the marketplace and run the risk of potentially selling his product at a loss in the summer should corn prices rise, he foregoes the gamble of a windfall profit (should corn prices fall) and enters a long hedge in the futures market. He buys 1 million bushels of July corn in the futures on April 15. This is the day he also enters into his cash contract for delivery of ethanol to his customer next August. The price of July corn on April 15 is $2.50. A drought develops, and in July, when he needs to go into the cash market to purchase the million bushels, the price of corn has risen to $3.00 in both the cash and futures. It has gone up by 50¢ per bushel, which is an additional cost to him, over and above the April price, of $500,000 (1 million bushels times 50¢ per bushel).

However, the futures have also risen by 50¢, and he sells the July futures contracts he purchased for $2.50 at the then prevailing price of $3.00. He thereby realizes a futures gain of $500,000, exactly offsetting the additional cash loss of $500,000. In this way, he assured his $50,000 gross profit on the transaction. If he had not hedged, he would have lost $450,000 on the cash contract instead of realizing a profit of $50,000.

Now if the weather had been good, and it looked as if a large crop was forthcoming, prices might have fallen to, say, $2.20 by July 15th. His cash corn cost in this case would be $300,000 less. If unhedged, and if he had entered into a cash contract for ethanol at the April price, he could have realized a windfall profit of $350,000 versus $50,000, all other factors remaining equal. If hedged, he loses $300,000 on the futures transaction (a fall of 30¢ per bushel times 1 million bushels). However, the ethanol producer makes this decision; if he can always enter into profitable contracts with his users, he knows he will remain in business. Sure, if prices of corn fall, he is out the extra $300,000 profit in this example (and this $300 grand probably was transferred from his account to some speculator(s) he'll never see, but this is OK—he's not in the casino business, his business is ethanol production), but he will gladly forego the chance of a windfall for the ability to keep his plant running profitably.

This simple example demonstrates that the objectives of hedgers and speculators are not the same. The speculator is always looking to make money on his transactions. The hedger, however, is not always looking to necessarily profit on the futures side of the transactions. The hedger's goals are to lock in a price that will assure a profit or prevent a loss for his business, either the production or consumption of some product. The bread baker who wants to lock in his future wheat purchase prices would use a long hedge in much the same way.

The reality

In these examples, I have kept the basis fairly constant, but in reality, it can change. If a short hedger (one who sells futures) experiences a widening of the basis (where cash prices have fallen to a greater degree than futures—either cash has fallen faster or risen slower than futures), a basis loss may result. In other words, the short hedger's cash position loss may be greater than the gain realized on the futures side of the transaction. Or, in a rising market, the gain on the cash side of the transaction would not be as large as the loss on the futures side.

Conversely, a basis gain would occur with a widening basis on a long hedge. The futures would rise in price to a greater degree than the cash. A narrowing basis yields additional gains for a short hedger (the cash falls less, or rises more, in relation to the futures) and incremental losses for the long hedger (the cash falls less, or rises more, in relation to the futures). Basis gains or losses are a risk to the hedger, but they're not nearly as big a risk as what is called flat price risk. The price of heating oil may move 20¢ per gallon in a couple of months, whereas the basis might move 1¢ either way. For example, the flat price move was a result of a warmer than normal winter whereas the basis change was due to the fact it was colder in New Haven than New York that particular winter. The speculator might analyze basis changes to help him determine the strength or weakness of a market, but this is really more of a hedger's concern.

It doesn't matter whether the user needs copper or soybean oil or to purchase Euros six months hence; any market in which prices fluctuate creates price risk for commercial participants, which in turn creates the need for a hedging tool. Remember, hedgers are not trying to make a killing in the market; they wish to offset price risks. The speculator, on the other hand, tries to make money by buying low and selling high (or vice versa). A speculator is a marketplace participant who is neither a producer nor a consumer of a commodity or financial instrument. By definition, he does not have or want the underlying commodity, and this participant could be you or me. Without speculators that the system would not work; they add liquidity. Speculators often take the other side of the bids and offers in the marketplace put out by hedgers. At times they take the other side of a speculative bid and offer, and at times different hedgers may be on both sides of a transaction. However, a trade cannot be completed unless someone is willing to take the other side, and if there were only hedgers and no speculators, the system would not operate smoothly. By assuming the risks the hedgers are trying to avoid, the speculators will make money when they are right and lose when wrong. In the earlier ethanol example, when the manufacturer made the $500,000 in the futures market, some person or persons lost that money. Those persons could have been speculators betting that the crop would be good and prices would fall. On the other hand, if prices did fall, this hedger's loss might have been made by speculators who were betting on lower prices.

Various types of traders fit the speculator category. Pit traders (also called locals) and other professional traders stand in the pit and trade for their own account, or trade for their own account from a computer screen. Many of them are scalpers, who are trading for ticks, or minor fluctuations. A local may, for example, scalp a small profit by selling five May copper contracts to a hedger who is buying at 98.10¢ per pound and then cover (or buy them back) from a speculator who is selling at 98¢ per pound. The tenth of a cent represents two price ticks (a tick is a minimum fluctuation); for copper this is .05¢ per pound or $12.50 per tick, or $25 per two ticks (or $125) for a two-tick move on a five-contract position. In this example, the local made a profit of $125, and he provided liquidity for both the hedger and the speculator. The hedger wanted to establish a longer-term buy hedge, and the speculator wanted to establish a new short position. The scalper is making a market here. At times, without the scalpers, a market can be thin, with buyers and sellers bidding and offering prices away from each other. Therefore, the local who is a scalper is providing an economic service, and this is why he is allowed to exist. I am not trying to say he is a wonderful person or a bad person; he is simply out to make a profit for himself (or herself—about 1% of pit traders are women). I am also not trying to insinuate that being a local on the floor is a license to print money. If a local's judgment is off, he can get caught in an adverse market swing, and his modest scalp will turn into a healthy loss.

When I leased my Exchange seat to a local because I was required to guarantee his performance, I received duplicate account statements. I saw as many losing trades and losing days as winning days, but on balance, he made money. He was a scalper (primarily) who traded hundreds of contracts each day, but it may have been in 2 or 5 or 10 lots at a time and for very short time periods. He was usually out, or flat, by the end of the day. At times he held a small position overnight, but most days he was out by end of the day, win or lose. The local, as an Exchange member, has the advantage of very low fees, just a few dollars per transaction. This is why the pit trader can trade so many contracts and trade them for just a few ticks and still make money. For the rest of us, commissions and slippage (the inevitable difference between buying the offer and selling the bid) would eat us up if we tried to scalp. Some pit traders are also position traders, which means they hold a position for more than minutes. Most off-the-floor speculators do not try to scalp. Although some speculators may be day traders (in and out during the same trading session), more hold a position for a few days, weeks, and in rarer cases months. When trading futures, holding a position for months is generally the exception (although the big money can be made with longer term positions). A speculator can be a big commodity fund manager, a lawyer in Toronto, a farmer in Montana (who is not hedging), a software engineer in London, or you! The risks in these markets can be high, so by definition, so are the rewards for the speculator.

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