As markets rise, optimism can paint a rosy picture of endless financial profits. Yet experienced investors know the tide can turn at any moment, transforming today's gains into tomorrow's losses. In these moments of uncertainty, the strategic use of futures to hedge positions becomes valuable for those looking to protect their investments from the ebb and flow of the markets.
Hedging limits losses, acting as insurance against adverse price changes. Futures contracts, agreements to buy or sell assets at a future date for a predetermined price, are often used for hedging purposes. This is because they allow investors to lock in prices and take offsetting positions, effectively securing against the unpredictability of market movements. Whether the goal is to safeguard stocks, bonds, or commodities, futures provide a way to manage financial exposure and mitigate risk. Below, we demystify the principles of hedging and show how futures fit in.
Key Takeaways
- By creating offsetting positions with futures contracts, hedgers can effectively lock in current prices.
- Futures contracts allow for the hedging of both long and short positions, offering flexibility choices when managing risk.
- Selecting the right futures contract and calculating the desired hedge ratio are key steps in the hedging process.
- While effective, hedging with futures has its own risks, requiring anyone trading in them to understand how they are best used.
Understanding Hedging With Futures
Let's say you have built a comfortable retirement portfolio that primarily tracks the S&P 500 index. Or you are a large commercial corn producer planning to harvest several tons in the fall. Or you're a portfolio manager with a significant position in U.S. Treasury bonds. In investing, we call these "positions," that is, the particular assets held in your portfolio. Your positions represent a wager on the future direction of that asset's price. A position is either "long," where you benefit from a rise in the asset's price, or "short," where you profit from a decline in value. Just as you need insurance against the hazards of driving or horrendous storms, you might need to hedge your positions to ensure market changes don't wreak havoc on your finances.
The value of your positions can fluctuate wildly because of economic changes, political events, or shifts in market sentiment. For your retirement account, a negative turn could mean you have fewer funds than you need after your working days are over. For the agricultural producer, you might not get the prices you need on this year's crop to plant the next one. For the portfolio manager, poor returns can impact the finances of many who rely on your strategic choices. Hedging is a safeguard to reduce or offset the risk that prices will move against you.
For example, taking an opposite position in a futures contract can protect your investment from losing its value. Suppose you hold a long position in stocks. You might hedge by taking a short position in S&P 500 futures contracts, thus insulating your investment from a potential decline in the index.
A futures contract is a standardized financial agreement between two parties to buy or sell an asset at a specified price at a future date. These contracts are traded on exchanges worldwide and can cover a wide range of assets, including commodities like corn, financial instruments like stock indexes, or government bonds. Futures are highly versatile, allowing you to tailor them to the specific needs of the hedger. They let you to lock in prices for the future, providing predictability and security in an otherwise uncertain market.
For the retirement portfolio tracking the S&P 500, using futures contracts helps ensure that a significant market downturn doesn't drastically reduce the value of a nest egg. For corn producers, hedging with futures secures a guaranteed price for their crops, protecting against a price drop that would turn a profitable harvest into a financial disaster. Likewise, for the portfolio manager, hedging with U.S. Treasury futures can protect against interest rate increases that would lower the value of the portfolio's bond holdings.
Hedging Strategies Using Futures
The most basic type of hedge using futures contracts is the "forward hedge." This locks in a price today so that future prices don't create unwanted losses.
Let's imagine an example from two professions that are as old as trading itself—the farmer who grows wheat that a baker transforms into bread and confections to feed a community. We'll see how going about their business requires the strategic use of hedging with futures contracts, where both parties want to lock in prices today to keep them producing into the future. We'll now turn to see how they might use "short" and "long" hedges in wheat futures.
Short hedge: The farmer's shield against financial disaster
Our example begins with a farmer planting winter wheat in the late fall. This wheat is not just a crop; it's the farmer's savings resulting from much labor and contains hopes for a future livelihood. However, the farmer knows that the price of wheat at harvest time next summer can change according to the whims of the weather, blight, a sudden bumper crop that increases everyone's supply, and countless other factors. The farmer uses a short hedge to guard against the risk of falling prices—which could turn a season of hard work into financial hardship.
A short hedge involves selling futures contracts for wheat. When the farmer sows the fields in October, the price of wheat is $600 per bushel. The farmer calls a broker with instructions to sell wheat futures that expire in June so they coincide with the harvest. The amount needed to cover the expected harvest is about 5,000 bushels.
Moving ahead to the late spring, the price of wheat has fallen to $500 per bushel, which would have been a loss of $100 x 5,000 = $500,000 for the farmer. However, at harvest, the farmer also buys back (or lets expire) the short futures position, which is a gain of $100 x 5,000. The farmer effectively locked in the price of $600 against his wheat crop at planting.
What would have happened if the price of wheat had risen instead to, say, $700 per bushel? The farmer would still have locked in the $600 price: the physical wheat would have increased by $100 but would have been offset by an equal loss in the short futures. That's the price of using futures: the farmer guards against risk while limiting the profits that can be made.
Long hedge: The baker's protection against rising costs
While the farmer is planting, a local commercial bakery estimates its needs for the following year. The head baker worries that should the prices for wheat, a key ingredient, go up, that would squeeze the company's already low margins and perhaps even cause some layoffs. To mitigate this risk, the company opts for a long hedge.
The long hedge involves buying futures contracts today against a future purchase of the underlying product or asset. At the start of the fiscal year in October, the baker estimates it will need 10,000 bushels of wheat. If wheat would just stay at $600 a bushel, the bakery would have a tight but manageable profit margin of 10%. Given its relatively large workforce and the money it's poured into new commercial ovens and delivery trucks, the baker buys futures expiring in 12 months, representing 10,000 bushels of wheat.
By October of the following year, wheat prices have fallen to $500. Rather than seeing added profits from the lower price of wheat, they still end up paying about $600 a bushel because losses in the long futures contracts offset the lower cost of wheat. However, if the price had instead risen to $700, almost a 17% increase, the bakery would have had to lay off workers and scale back operations. The hedge protects these jobs and keeps the company going into the next year by allowing the $100 per bushel profit in the long futures position to offset the higher wheat prices.
Factors to Consider in Hedging a Position
The first step in any hedging strategy is identifying the exposure you wish to hedge. The goal is to understand how changes in the price of your asset would affect your financial position and what price changes would be too costly for you.
As a hedger, you're not seeking the "perfect hedge." A hedge that eliminates any exposure to price changes might seem ideal. However, it might remove any potential benefit from favorable price moves. Imagine a portfolio manager concerned that rates may rise and lower the value of the $10 million in bonds they hold. To fully hedge the $10 million in bonds, they might sell bond futures to offset the interest rate exposure. If rates rise 1% as predicted, the portfolio value declines, losing about $500,000. However, the futures gain about $500,000. The portfolio returns to even, fully protecting against losses and capping potential profits. If rates fall 1% instead, the portfolio value increases by about $500,000, but now the futures contract produces $500,000 in losses. Overall, the combined futures-portfolio position again returns to breakeven.
By perfectly hedging against risk with interest rate futures, the portfolio manager might sacrifice profits to try to eliminate the risk of downside losses. In addition, there are costs for hedging: fees, commissions, and margin requirements. These charges can add up quickly, especially for smaller positions where the cost of hedging might outweigh the benefits. In these situations, a partial hedge can be a more cost-effective strategy, offering a compromise between risk management and profit-seeking.
So, within the range between doing nothing to hedge for the future and working out the supposed perfect hedge, you face a trade-off between seeking profit opportunities versus precisely offsetting potential losses. Striking the right balance depends on your risk tolerance and market outlook. As such, most hedgers prefer to hedge their position only partially. By doing so, they maintain their potential to profit from price changes while still protecting their portfolio against adverse shifts.
The hedge ratio is how many futures contracts are needed to adequately hedge the exposure of the underlying asset. This calculation involves assessing the size of your position in the asset and the contract size of the futures contract.
Determining the Appropriate Futures Contract to Use
Once you've decided the right balance in hedging for you, the next step is to select the futures contract that best matches your needs for your asset's expected price moves and delivery time.
Futures contracts are standardized and tailored to particular commodities, financial instruments, and indexes. Each contract will represent a specific asset quantity, have predetermined delivery dates, and be traded on certain exchanges. While this standardization makes more liquidity and efficiency in trading futures possible, it can also present a challenge when the available futures contracts do not align well with your needs.
For instance, a small-scale producer might find that the minimum contract size for wheat futures is far larger than the quantity they wish to hedge. Similarly, a financial institution looking to hedge its interest rate exposure might not find a futures contract that aligns with the maturity dates of its bonds. A stock investor may have a portfolio that doesn't match any particular index weightings.
When this happens, hedgers must be creative and employ what's known as a "cross hedge." This involves selecting a futures contract that, while not a perfect match, has characteristics or price action that are closely correlated with the position they're trying to hedge. For example, a stock investor may decide that the S&P 500, while not precisely mirroring their diversified portfolio, is a good enough representation of the broader market to suffice. At these times, it's crucial to choose a contract that aligns as much as possible with the asset you're hedging so it's effective.
Risks, Limitations, and Alternatives when Hedging with Futures
Besides problems at times finding exact futures to match your underlying assets and the lack of flexibility that comes with standardized futures contracts, here are additional risks when hedging with futures:
Basis risk: This arises when there's a mismatch between the price movement of the underlying asset and the futures contract used for hedging. This can happen because of a cross hedge or because of differences in location, commodity quality, or contract settlement timing.
Liquidity risk: While major futures contracts are highly liquid, lesser-known or niche contracts may not be, making it difficult to enter or exit positions without impacting the price.
Market risk: Even with a well-planned hedge, the futures market can move in unexpected ways. Significant events can lead to market gaps where prices jump significantly from one level to another without trading in between, potentially leaving hedgers exposed to unanticipated losses.
Operational risk: The complexity of managing futures contracts, including the need for constant monitoring and adjustments, poses an operational challenge. Missteps in managing these details can undermine the effectiveness of a hedge.
Rollover risk: This occurs when a futures contract nears its expiration, and the hedge needs to be extended by entering into a new contract. Rolling over a position can introduce the risk of price discrepancies between the expiring and new contracts.
Alternative strategies to consider when hedging
Given the limitations and risks associated with futures, it may be beneficial to consider alternative hedging strategies:
Forwards: Like futures, forwards are contracts to buy or sell an asset at a future date for a price agreed upon today. However, forwards are not standardized and can be customized to fit the exact needs of the hedger, though they come with higher counterparty risk.
Insurance: Traditional insurance products may provide a more straightforward hedging solution for certain types of risk, such as crop failure or natural disasters.
Options: Unlike futures, options provide the right, but not the obligation, to buy or sell an asset at a predetermined price. This can offer more flexibility and potentially lower risk, as the maximum loss is limited to the premium paid for the option.
Swaps: These are agreements to exchange cash flows in the future according to a prearranged formula. They can be customized to hedge various risks, including interest rates, currency, and commodity prices.
How Do Long and Short Hedges Differ?
A long hedge is used when you anticipate needing to purchase an asset in the future and want to lock in the price now to protect against price increases. It's commonly used by companies needing to secure a future supply of raw materials at a predictable cost. In this strategy, you buy futures contracts to cover the anticipated purchase, ensuring that if prices rise, the gains from the futures position will offset the higher costs of buying the asset.
A short hedge works in reverse and is employed to protect against a decline in the price of your assets. It's useful for producers or investors who want to lock in a selling price for their commodities or securities.
When Were the First Futures Hedges Used?
Hedging with futures dates back centuries. However, the formalized use of futures contracts is often traced to the establishment of the Chicago Board of Trade (CBOT) in 1848. The CBOT began as a market for forward contracts but evolved into a standardized system for futures contracts by 1865. These developments allowed farmers and buyers to lock in prices for future delivery, effectively hedging against price fluctuations. Although these early contracts might not have been called "hedges" in the way we understand the term today, they served the same purpose of protecting against price risk.
How Do Speculators Use Futures Contracts in the Financial Markets?
Speculators use futures contracts to profit from anticipated price movements in the underlying asset. They enter into a futures contract predicting that the asset's price will move in a particular direction before the contract expires. For example, if speculators believe the price of wheat will rise, they might buy a futures contract for it. If the price increases, they can sell the contract higher, thus realizing a profit. However, there are perennial concerns that speculators could distort market prices, affecting consumers downstream from market trading.
The Bottom Line
Hedging with futures can mitigate financial risk by locking in prices today for future transactions, but it's not a one-size-fits-all solution. While effective in reducing exposure to price volatility, it cannot eliminate all forms of risk, such as basis, operational, systemic, liquidity, and counterparty risks. In addition, the cost of implementing hedging strategies may sometimes outweigh their benefits. Despite these limitations, hedging remains a crucial part of risk management for investors and businesses, offering a way to manage uncertainty in volatile markets.
