Using Futures to Hedge

Hedging is a way of protecting your investments from risks associated with adverse turns in the market. Hedging normally involves taking a position in a related instrument that will help offset any adverse changes in your investment’s price. In the Futures market, hedgers seek to lock in a particular price level weeks or months in advance for the products that they want to buy or sell on the market. Their futures position helps to protect their tangible investment (the product itself) from adverse price changes before the physical sale occurs.

Hedging Example

Mr. Olsen is a jeweler who is currently in possession of 100 ounces of physical Gold (around 3,2 kg). He is concerned about the possibility of declining world prices on gold and wants to protect his asset from a possible decline in value. He knows that 1 contract of Gold at CBOT exchange in Chicago exactly matches his own quantity and therefore sells 1 ZGM6 contract at $665.00/ounce.

Market Scenarios

The market can move in one of two ways:

• Price on the world market goes up, e.g. to $670/oz. Result: His short Futures contract will be a losing position of $500, but his physical Gold will increase by approximately the same amount ($500). Risk = 0
• World market price will decline, e.g. to $660/oz. Result: Mr. Olsen's physical Gold will decline in value with $500 but he will gain about the same amount ($500) on his short Future contract. Risk = 0

The Hedger's Trade-of

The benefit of hedging is that the hedger is able to protect his/her investment from adverse changes in the market price level. The downside is that the hedger is not able to benefit from any favourable changes in the market.

In the next article we will look at the other major type of Futures trader, the Speculator.