Series 3: 1.3.5.3. Hedging

1.3.5.3. Hedging

Hedging is an activity that seeks to protect an investor’s assets or liabilities from adverse price fluctuations by acquiring an opposite position in derivatives. Unlike speculation, which willingly accepts more risk to earn the possibility of additional profits, the primary purpose of hedging is to willingly cap profits to limit or reduce price risk. A holder of a large stock position might wish to hedge the risk of falling prices by purchasing an option on that stock. A farmer who has just planted 10,000 acres of wheat might want to hedge the risk of falling wheat prices by shorting a wheat futures contract in the month he expects to market his harvest. This futures contract helps him lock in a price for his wheat. While the speculator willingly increases risk to maximize potential gains, the hedger deliberately fixes his gains in order to reduce his risk of loss.

Long and short hedging. A hedge transaction involving a long position in the spot market and a short position in the futures market is called a short hedge. A grain elevator operator who holds an asset (long the asset) and is concerned about a decrease in its price might use a short hedge by selling a wheat futures contract. A short hedge is also called an output hedge because producers will use a short hedge to lock in the price of their product (output) for sale and delivery in the future.

A General Mills supplier that needs to purchase wheat for