What Is a Short Hedge?
A short hedge is an investment strategy used to protect (hedge) against the risk of a declining asset price in the future. Companies typically use the strategy to mitigate risk on assets they produce and/or sell.
A short hedge involves shorting an asset or using a derivative contract that hedges against potential losses in an owned investment by selling at a specified price.
Key Takeaways
- A short hedge protects investors or traders against price declines in the future.
- It is a trading strategy that takes a short position in an asset where the investor or trader is already long.
- Commodity producers can similarly use a short hedge to lock in a known selling price today so that future price fluctuations will not matter for their operations.
- A short hedge is the opposite of a long hedge, which protects against rising prices.
Understanding a Short Hedge
A short hedge can be used to protect against losses and potentially earn a profit in the future. Agriculture businesses may use a short hedge, where "anticipatory hedging" is often prevalent.
Anticipatory hedging facilitates long and short contracts in the agriculture market. Entities producing a commodity can hedge by taking a short position. Companies in need of the commodity to manufacture a product will seek to take a long position.
Companies use anticipatory hedging strategies to manage their inventory prudently. Entities may also seek to add additional profit through anticipatory hedging. In a short-hedged position, the entity is seeking to sell a commodity in the future at a specified price. The company seeking to buy the commodity takes the opposite position on the contract known as the long-hedged position. Companies use a short hedge in many commodity markets, including copper, silver, gold, oil, natural gas, corn, and wheat.
Commodity Price Hedging
Commodity producers can seek to lock in a preferred rate of sale in the future by taking a short position. In this case, a company enters into a derivative contract to sell a commodity at a specified price in the future. It then determines the derivative contract price at which it seeks to sell, as well as the specific contract terms, and typically monitors this position throughout the holding period for daily requirements.
A producer can use a forward hedge to lock in the current market price of the commodity that they are producing, by selling a forward or futures contract today, in order to negate price fluctuations that may occur between today and when the product is harvested or sold. At the time of sale, the hedger would close out their short position by buying back the forward or futures contract while selling their physical good.
Example of a Short Hedge
Let's assume it's October and Exxon Mobil Corporation agrees to sell one million barrels of oil to a customer in December with the sale price based on the market price of crude oil on the day of delivery. The energy firm knows that it can comfortably make a profit on the sale by selling each barrel for $95 after considering production and marketing costs.
Currently, the commodity trades at $100 per barrel. However, Exxon believes it could fall over the next few months as concerns over the oil supply recede. To mitigate downside risk, the company decides to execute a partial short hedge by shorting 250 Crude Oil December Futures contracts at $100 per barrel. Since each crude oil futures contract represents 1000 barrels of crude oil, the value of the contracts is $25,000,000 (250,000 x $100).
At the time of delivery to the customer in December, the oil price has fallen and now trades at $94. Exxon consequently covers its short position for $23,500,000 (250,000 x $94) with a profit of $1,500,000 ($125,000,000 - 23,500,000). Therefore, the short hedge has offset the sale's loss caused by the decline in the oil price.
What Is a Long Hedge?
A long hedge involves purchasing a futures contract (or other long position) to protect against rising prices It is often used by manufacturers who require certain inputs and do not want to risk prices rising on those commodities.
How Does a Short Hedge Lock in a Price for a Producer?
Say that a farmer produces corn and wants to lock in today's price, when the seeds are planted. The farmer does not want to risk the price going down between now and the harvest time several months into the future. They can sell futures contracts that expire at or after the harvest month. At harvest, the physical corn is sold and the futures contract either expires or is bought back to close the hedge. Regardless of what the price of corn does in the interim, every dollar change in the price of corn will be offset by the opposite position in the futures contract.
Are Short Hedges Common?
Yes, short hedges are used by many types of producers from oil and minerals companies to agriculture and farming. In fact, more than 47,000 American farms use futures or options contracts to hedge against falling prices, according to the U.S. Department of Agriculture.
