Hedging and Speculating with Futures

The casual market observer may see little differentiating hedging and speculating, but for those more involved in the futures markets, the objectives for each task are clearly distinct. While the underlying goal for both is to earn a profit from transactions, a hedge is intended to protect an open position while speculating refers specifically to earning a profit. This article will explain in more detail how dealing in futures transactions can be used to meet either objective.

Hedging with Futures

Hedging is a practice intended to offset the risk associated with an investment. While risk levels may vary, all investments carry some degree of risk which no hedging strategy can completely eliminate. Thus, the goal of any effective hedge strategy is to reduce the risk to an acceptable level and at an acceptable cost to the investor.

Relationship Between Cash Market Price and Futures Prices

As the futures markets expanded and the buying and selling of futures contracts themselves grew in popularity, investors noticed that a predictable relationship existed between the price of the futures contract and current market prices of the underlying commodity. For instance, if the market price of crude oil was rising, then the price of oil futures also tended to rise. While on the surface, this relationship hardly seems surprising, its existence does provide hedgers with the means to reduce exposures in the cash market.

Implementing a Long Hedge

Building further on our oil futures example, imagine an oil refinery in the early part of the year planning for the busy summer driving season. The refinery knows that it needs to purchase 5 million additional barrels of oil to make up shortcomings it has in its current crude oil inventory. The world price for oil has been increasing and as demand increases, prices are likely to continue to rise.

Imagine also that the current market price is $100 per barrel and this is the cost that the refinery wishes to maintain for the next six months. In an attempt to offset the expected price increase, the refinery turns to the futures market to purchase futures and finds a June crude futures contract currently trading at $105 a barrel. Even though this represents a $5 increase in the current price, the refinery expects the price of oil in June to increase even more which should see a parallel increase in the value of the futures contract. Therefore, the refinery buys enough contracts to make up for the shortage in their inventory of 5 million barrels. This is known as a long hedge.

It is now a few weeks before the start of June, and because the market price of oil has increased to $115 a barrel and seems likely to rise further, oil futures are currently trading at $120 a barrel. The refinery can now sell the futures and use the profit to offset the increase in the market price of oil.

Review the following breakdown to see how the refinery created this crude oil hedge:

The refinery’s price target per barrel is $100 for a total cost of $500 million dollars.

• Purchase oil futures – 5,000,000 @ $105 = $525,000,000
• Sell oil futures (June) – 5,000,000 @ $120 = $600,000,000
• Profit on oil futures = $75,000,000

By applying the profits to the cost of purchasing 5 million barrels of oil at the current market price of $115 per barrel, the refinery has achieved an effective per barrel cost of $100:

• Current market price – 5,000,000 @ $115 = $575,000,000
• Subtract profits from selling the futures = $75,000,000
• Total Cost when futures profits factored in = $500 million

Granted, this is a very neat little example and real-world hedging rarely works out so precisely, but it illustrates how a long hedge functions. Essentially, if you have an upcoming expenditure, you are short that commodity so you must take on a long hedge in order to cover your short position. Next we will look at a simple example illustrating a short hedge.

Implementing a Short Hedge

In the long hedge discussion above we noted that a long hedge was desirable when attempting to minimize the risk that a future payable could balloon by the time it is due. The short hedge is for the opposite scenario where you will be selling a commodity in the future and you want to ensure that the price does not decline. In other words, you are long a certain commodity and want to maintain the value of this commodity until the time you sell it – for this, you can turn to a short hedge in the futures market.

To understand how a short hedge works, consider the case where a woodlot operator hires a team of students to cut pulp wood for the summer. The current price for pulpwood is $220/ten tons and this is the price the operator needs to recover in September when he plans to sell the pulp wood. However, in this part of the country, cutting pulp wood is a common summer job for students and there could be a surplus of pulp wood in the market by September and this usually causes the price to fall.

To avoid this, the operator needs to sell pulp wood contracts (each contract is 10 tons) for September delivery. In total, the operator shorts 1,000 contracts at $230 per contract to cover the 10,000 tons of pulp wood he expects to have ready for market. This means the operator is now short $230,000 (1,000 x $230) worth of pulpwood futures.

By September, the market price has – as the operator predicted – dropped and is now at $200/ten tons which has caused a similar drop in the futures price to $210 per contract. To close his short position, the operator buys 1,000 contracts at $210 each for a total cost of $210,000. This means that the operator has profited by a total of $20,000 on the futures contracts:

• Short = 1000 x $230 = $230,000 (this how much the operator received for the short sells)
• Close = 1000 x $210 = $210,000 (this is how much the operator paid to close the shorts)
• Profit = $20,000 (this is the profit retained by the operator)

Meanwhile, the operator sells his 10,000 tons of pulp wood at the market price of $200 for each ten-ton lot for a total of $200,000. When this amount is combined with the profit from the short sale, the operator actually pockets $220,000 and this is the amount that he determined was required in June to ensure a profitable summer harvest.

Once again, this example is for illustrative purposes only and it is extremely unlikely that any hedge strategy could ever be so exact. Despite this assertion, the examples do show how futures contracts can be used to reduce the risk of a price change affecting the price of the underlying commodity at a future time.

Taking Delivery of Underlying Commodities

Some readers may be asking why – instead of buying and selling futures contracts to hedge the price of oil as explained in the first example – did the oil refinery not simply buy a futures contract at a favorable price and then take delivery of oil on the maturity date? This seems much easier than buying and selling contracts and using those proceeds to help offset price changes.

Recall that earlier we noted that only about 3% of futures contracts result in the physical delivery of a commodity and that the vast majority of futures contracts were cash settled. There are a couple of reasons for this, but the most relevant reason being the logistics and facilities required to manage the transfer of the commodity – after all, it is much cheaper to transfer money between financial institutions than it is to handle a one-time shipment of 5 million barrels of oil. Also, it is possible that the refinery may only be able to process and store half this amount at any one time so having the cash in hand and then being able to order delivery as needed is preferable.

In other cases, the quality standards the buyer requires may not be available at the time they wish to enter into a futures contract. Almost any grade or standard of the commodity is acceptable for hedging purposes and once the open positions are closed, proceeds from the sale can be used to offset price changes or for other purposes as deemed necessary.

Speculating with Futures

True speculators in the futures market do not – under any circumstances – ever wish to take physical delivery of the underlying commodity. In fact, if you as an investor have an open position with your broker nearing maturity, you can expect a notice from your broker informing you that you have a position due to mature. If you have an open long position, you must either close it or be prepared to take delivery of the commodity at the full value of the contract – if you have an open short position, you must either close it or be prepared to delivery the commodity in the futures contract.

Speculators are an important part of the futures market and are responsible for much of the liquidity in the market. However, speculators don’t just buy and sell at random – at least not successful speculators! Using various methods of markets analysis speculators attempt to identify trends that suggest the direction the market is likely to take. If for instance, it seems likely that the price of rice will increase, then going long in rice futures could prove profitable as the market price of rice will be higher when the contract matures then it is presently. On the other hand, if it seems that rice will decline, then going short – selling now at a higher price – is the correct strategy.

Because speculating in futures requires a good understanding of the market conditions and other factors that could influence commodity prices, speculators tend to specialize in only one or two sectors. Some may specialize in currency futures and various financial futures, while others may concentrate on agricultural products such as cattle and hog futures.