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:
- You take a short position on an asset, which means you’re betting its price will fall.
- 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?
Businesses that make or need a lot of a certain thing, like oil or corn, use short hedges to avoid surprises in prices. For example, a farmer might use it to make sure they can sell their crops at a good price, even if prices crash by harvest time.
Short Hedge Example
Imagine you’re an oil company. You agree to sell oil to someone in a few months. Right now, oil costs more than what you need to make a profit. But you think prices might drop. So, you set up a short hedge by making a deal to sell oil at today’s price, even though you’ll actually sell it later.
Example with Numbers
Let’s say it’s October. Exxon thinks oil prices might drop by December, when they have to sell a million barrels. They’re okay if they sell oil at $95 per barrel. Right now, oil is $100 per barrel. They decide to hedge by agreeing to sell a part of their oil at $100 per barrel, even though they’ll actually sell it in December.
Come December, if the oil price drops to $94, they’ll still sell that hedged part at $100. They’ll lose on the spot market, where the price is now $94, but the hedge helps them not lose too much.
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.