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published-date Published: October 7, 2023
update-date Last Update: January 26, 2024

Short Hedge

What’s a Short Hedge?

A short hedge is a way to protect against the chance that the price of something you own, like a stock or commodity, will go down in the future. It’s like an insurance policy for investments. Companies and investors use this tactic to lock in a sale price for something they’ll sell later, no matter what happens to the market price.

How a Short Hedge Works

Here’s how it’s done:

  1. You take a short position on an asset, which means you’re betting its price will fall.
  2. Or, you use a contract called a derivative to agree to sell at today’s price, even if you’ll deliver the asset later when the price might be lower.

Why Use a Short Hedge?

A short hedge serves as a protective measure against potential losses and the opportunity to make a profit in the future. In industries like agriculture, a practice known as “anticipatory hedging” is commonly employed.

Anticipatory hedging involves the use of both long and short contracts in the agriculture market. Producers of a commodity may opt for a short position to hedge their risk, while companies that require the commodity for manufacturing purposes take a long position.

These anticipatory hedging strategies are valuable for prudent inventory management. Additionally, they offer the potential for increased profits through anticipatory hedging. In a short-hedged position, an entity aims to sell a commodity at a predetermined price in the future. Conversely, the company seeking to purchase the commodity takes the opposite position in the contract, known as the long-hedged position. Short hedges are employed in various commodity markets, including those for copper, silver, gold, oil, natural gas, corn, and wheat.

Commodity Price Hedging

Commodity producers can secure a favorable selling price in the future by adopting a short position. In this scenario, a company engages in a derivative contract to sell a commodity at a predetermined price at a later date. The company decides on the price and specific terms of the derivative contract and typically monitors this position regularly for its daily operational needs.

A producer can employ a forward hedge strategy to lock in the current market price of the commodity they are producing. This is done by selling a forward or futures contract today, effectively mitigating the impact of price fluctuations that may occur between the present day and when the product is ready to be harvested or sold. When it’s time to sell, the hedger closes their short position by repurchasing the forward or futures contract while simultaneously selling their physical commodity.

Short Hedge Example

Imagine a wheat farmer named Sarah who expects to harvest a significant quantity of wheat in six months. She is concerned about the possibility of falling wheat prices by the time she’s ready to sell her harvest. To protect herself from potential price declines, Sarah decides to implement a short hedge.

Here’s how Sarah executes the short hedge:

  1. Entering the Short Hedge: Sarah enters into a futures contract to sell a specific quantity of wheat at a predetermined price six months from now. Let’s say the current market price for wheat is $5 per bushel, and Sarah expects to harvest 1,000 bushels in six months. She decides to lock in the current price and enters into a futures contract to sell 1,000 bushels of wheat at $5 per bushel in six months.
  2. Monitoring the Hedge: Over the next six months, Sarah monitors the wheat market closely. If the market price of wheat falls below $5 per bushel, she knows she has protected herself because she can still sell her wheat at the agreed-upon price of $5 per bushel, regardless of the market price.
  3. Closing the Hedge: Six months later, when Sarah is ready to sell her wheat, she checks the market price. If the market price has indeed fallen to, let’s say, $4 per bushel, she closes her short hedge by selling her physical wheat at the market price of $4 per bushel. At the same time, she buys back the futures contract at $5 per bushel, which offsets her short position. This means she sells her physical wheat for $4 per bushel but makes up the $1 per bushel difference with the profits from the futures contract, resulting in her effectively selling her wheat at the desired price of $5 per bushel.

In this example, Sarah successfully used a short hedge to protect herself from falling wheat prices, ensuring a stable selling price for her harvest even if market prices declined. This strategy allowed her to manage the risk associated with her wheat production effectively.

The Takeaway

A short hedge helps you set a future sale price no matter what happens in the market. It’s a way to reduce risk if you think prices will fall, and it’s especially useful in markets like oil, gold, or agriculture.

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