What is a hedge? A hedge is an investment to manage and lessen the risk of adverse price movements in an owned asset. Normally, a hedge consists of taking a counterbalance position in a related security, such as a futures contract.
Hedging has always been significant for the agricultural community as a way to protect the producer from price fluctuations or to insure that they will be able to lock in a profitable price for their crops. But hedging is not an investment tool reserved only for those who grow corn, wheat and beans. An investor with a portfolio heavy in stocks will look to sell the applicable index that includes the stocks they own. If you have gold mine stocks, you should be looking to sell the gold futures. If you have investments held in overseas markets effected by the fluctuation of foreign currencies, you should be looking to the US dollar and currency futures to protect your longer term investments. If you need to purchase natural gas or heating oil at a later date, you should consider locking in a lower price now.
As with any risk/reward trade off, hedge results in lower returns than if you “bet the farm” on a volatile investment but it also lowers the risk of losing your shirt. Diversification is the key to investment success. Learn more about using the futures markets in tandem with your other investments. Request our Hedging Guide.
Hedger vs. Speculator
US merchants needed to ensure there were buyers and sellers for their products (commodities). The result was a forward contract to buy and sell commodities (futures). The days of farmers bringing samples of their crops for inspection to the trading floor have evolved into an arena that sets future prices with the aid of the speculative investor. Hedgers trade to secure the future price of the commodity (or financial instrument) of which they will take delivery, and later sell in the cash market. They need to protect themselves against future price risk.
Then there are the investors who speculate on the price change potential. A speculator makes risky investments, anticipating a major change in the future price and trades solely for profit. Financial speculation involves the buying, holding, and selling to profit from fluctuations in its price as opposed to buying it for use.
The interaction between speculators and hedgers is what makes the futures markets efficient. A hedger may try to take the speculator’s money and vice versa. How? A speculator may buy a contract at a low price anticipating that it will be worth more closer to expiration. The hedger sells at that same low price because he expects the price to decline further, therefore protecting his product from lower cash prices. Speculators assume price variability, which makes the transfer possible in exchange for the potential to gain. Thus, a hedger and a speculator can both be very happy from the outcome of price variability in the same market.
Together they provide the volume and the volatility that necessary to set future prices and protection.