Using Commodity Hedging Strategies to Manage Price Risk

By Patrick Sekhoto  

Commodity traders make profits primarily through two different ways; speculation and hedging. The latter is a risk management strategy used to protect an investment against losses and shielding its profits. Consequently, the former is a more aggressive strategy, purely driven by profit. Even though the two strategies can be used at the same time, it is critical for traders to understand how hedging works and why it is necessary. Ideally, commodity-hedging strategies are one of the basic tips to profit selling commodities. Here is a quick outline on how to use this simple strategy to maximize your profits exponentially.

What is a hedge fund trader?

A hedge fund trader is an individual or company that involves in a business related to a specific commodity. Preferably, a hedge fund trader could be a producer of the commodity or rather a company interested in purchasing a commodity in future. Hedging allows each party to limit their risks in the commodity markets.


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Why do traders hedge?

It is not possible to predict the direction commodity prices are taking with 100% accuracy. Apart from the direction of prices, traders also need to know the specific time frame for such changes. Instead of stressing out to get these two factors right, traders can opt to make more profits by using the hedging strategy.

How does hedging work?

Physical commodities are bought or sold by traders in a cash market. Meanwhile, contracts involving the delivery of these goods at a future date are availed within the futures market. Even though the cash market and the futures price are closely related, they do not move in a similar manner. This is the reason why the term "Basis" is used during transactions. Ideally,  (Basis = Cash Price - Futures Price).


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Go short or long?

Investors and traders have two choices to make; go short or long. Going short involves borrowing the contract from a broker and selling it away before buying it back at a lower price. Conversely, going long involves buying a commodity today with the expectation that the selling price will make a profit at a later stage.

Deciding to go long with your hedging strategies weakens the Basis. This is occasioned by the fact that the cash price decreases in a similar manner to the futures contract. Consequently, shorting can be beneficial whenever the Basis increases. The increasing cash price is always relative to the futures contract. Remember that the basis can possibly move in the opposite direction to the price levels. Yet, what matters is the absolute difference between the two.



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Potential hedging risks

As producers hedge against physical goods, it is considered not risky is based on a short - term period. However, the hedge trader could lose out on all their potential savings if the wrong price movements are forecast.

Should you add hedging to your trading plan?

Hedging is one of the greatest tools to manage risks involved in commodity futures trading. If possible, the goal of hedging should be concentrated at transferring price risk and setting the prices one will pay or receive within a determinable range. Reducing exposure to surprises allows traders to confidently plan their operations.

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