Commodity Hedging – How to use Hedging in Commodity Trading?
Know everything about Commodity Hedging here. Understand what is commodity hedging, how to use hedging in commodity market, types of hedging strategies, advantages & more.
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About Commodity Hedging
The American billionaire Paul Tudor Jones once said, “Don’t focus on making money, focus on protecting what you have.”
One of the most basic things people must remember while trading is capital preservation. In the commodity markets, people generally trade in futures of commodities which have huge lot sizes.
Therefore, the money at stake is high, which makes it important to preserve the capital. This is because a single unfavorable trade can lead to huge losses.
Because of this huge capital, people are advised to hedge themselves while trading in the commodity market. Hedging is the practice of taking an offsetting position in the market to avoid losses.
In simple words, the offsetting position means taking a similar trade with a similar quantity in the opposite direction.
The commodity markets are not the same as the stock market. Therefore, hedging techniques are also different.
Hedging and Hedgers
As mentioned earlier, hedging is the technique of taking an offsetting position in the market to eliminate the risk of price volatility.
In most cases, this technique is used by the producers of that commodity or a company that is a bulk buyer of that commodity.
However, not every person in the commodity market uses this technique. Some are there to hedge while others are there to speculate.
Speculation is the technique of booking profits from the price change in security while hedging tries to eliminate the price change caused due to volatility.
Let us now look at the characteristics that define a hedger so that it becomes easy to indent if the trader is hedging or speculating.
Risk factors: In simple words, hedgers can be described as risk-averse while the speculators are risk lovers.
This is because the hedgers try to eliminate the factor of risk in the commodity market. On the other hand, the speculators aim at booking profits from the risk that causes price change.
Motive: A hedger is a person who has already taken a position in the market for an underlying security. To avoid any losses, he takes an offsetting position.
Since the trader now has two positions for the same security, his profit protentional is limited or nil in some cases.
Therefore the motive behind hedging is capital preservation. At the same time, the motive behind speculation is profit maximization.
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Hedging using Commodity Futures
Future trading is one of the most commonly used practices while trading in the commodity market.
Futures are a form of derivatives under which the buyer and the seller agree to sell a commodity at some point in the future.
However, the price for that is fixed on the date of the agreement itself. Therefore, the seller could hedge himself against the volatility in the market that may arise in the coming future.
Let us take an example to see how hedging works in the case of the commodity market.
For instance, a farmer who produces cotton has a production of 100 bales in a year. On a particular date, cotton is trading at Rs.19000 per bale, but the market volatility is very high.
The farmer feels that the current rate will suffice his needs, and he does not want to deal with the volatility that might cause price changes in the future. However, the crop is not yet harvested, and it might take almost a month.
Therefore, to hedge himself from the volatile market, the farmer will get into a futures contract with a buyer. Under this, the farmer agrees to sell all his produce after a month.
However, the rate will be fixed on the date of the contract itself. So, the farmer sold the produce at a rate of Rs.19000 per bale under a futures contract.
On the date of expiry of the contract, there are two possible scenarios:
Scenario 1 – The prices of cotton on that day shoot up to Rs.20,000 per bale: Since the trader has already sold his produce at a rate of Rs.19,000 per bale, he will not be able to benefit from the price rise.
Therefore, the trader ends up selling the stock with a market price of Rs.20,000 per bale at a rate of Rs.19,000 per bale.
This will lead to a loss of Rs.1000*100 = Rs.1,00,000 when compared to the market price.
Scenario 2 – The prices of cotton on that day dropdown to Rs. 18,000 per bale: Since the trader has already sold his produce at a rate of Rs.19,000 per bale, he will not be affected by this fall in price.
Therefore, the trader ends up selling the stock with a market price of Rs.18,000 per bale at a rate of Rs.19,000 per bale.
This will lead to a profit of Rs.1000*100 = Rs.1,00,000 when compared to the market price.
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Types of Hedging Strategies in Commodity Trading
As discussed earlier, hedging neutralizes the effect of trade. Therefore, it helps you in limiting your losses but also minimizes the profit potential.
However, there are ways to control the level up to which you want to hedge yourself. The quantity of offset position decides your level of hedging.
Let us now try to understand the basic types of hedging strategies used in commodity trading:
In this strategy, the trader completely neutralizes the effect of trade with the help of an offsetting position.
The trade takes a position for the same commodity and quantity in the opposite direction.
Therefore the losses incurred through the first position and recovered with the help of the second position, which neutralizes the effect of trade completely.
In this strategy, the trader neutralizes the effect of a trade to a limited extent only by taking an offsetting position.
However, this is different from full hedging in terms of quantity and commodity chosen. Under this, the commodity chosen to hedge the first trade is similar but not the same.
The quantity chosen is also not equivalent to the entire amount of the first trade. In this form of hedging, only a portion of the amount is hedged.
Therefore, the trader needs to keep a close eye on the market conditions to avoid losses and exit whenever required.
This form of hedging is different from the previous two in terms of application. This is because the previous two strategies are implemented as soon as a trade is taken.
However, this strategy is applied after analyzing the market conditions. Therefore, the trader does not enter an offsetting position until the last moment.
Sometimes this strategy can lead to huge losses as well. With the greed of earning more profits, the trader avoids hedging until the very last moment.
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Advantages of Hedging in Commodities
Limiting Losses: The primary motive of hedging is to limit the losses, and it serves it fairly well. Hedging, when done correctly, can help in minimizing the losses to a huge extent.
Higher Liquidity: Hedging helps in increasing the liquidity in the markets. This is because a trader who holds a position in the market will have to infuse more funds to offset it.
In some cases, traders dealing in multiple commodities have to take multiple positions to hedge every trade.
Therefore, the funds invested in the market increases, which lead to higher liquidity in the market.
Conclusion – Commodity Hedging
We hope that this article has been helpful in understanding Commodity Hedging process. With the help of types of hedging strategies, you can use them in required scenarios.
Advantages will tell you about how commodity hedging is useful & how it can be best used. You have also got to know about how hedging works for commodity futures aswell.
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