Hedging against Commodity Risks

Hedging against commodity risk is a different process depending on what type of market participant you are. The objective of the true hedger, a producer or consumer of the actual commodity, is not the same as if you are a speculator, a trader who is trying to profit from moves in the market. In the first case, hedging is the very reason for being a market participant. In the latter case, you can hedge against commodity risk by buying certain types of options, by trading in interest-rate-sensitive futures or by maintaining a well-diversified portfolio.

Types of Market Participants–True Hedgers

Those markets participants that transact in commodity futures as a pure hedge do so because of their underlying position in the actual commodity. A farmer is naturally long those commodities he or she grows, while a bread manufacturer is naturally short the raw materials needed to make bread. These participants hedge their commodity risk by taking positions that will profit when their natural position is challenged. A farmer will sell futures so that if the price falls, his profits on the futures offset his loss on the crop. The producer buys futures so that if the price rises, his profit on the futures will offset the higher price he now must pay for the crop.

The Speculator

The bulk of market participants are traders who wish to profit from moves in the price of a commodity by trading in securities. These traders make trades based on their beliefs as to the direction the price of the commodity will move. If you believe that the price of wheat will rise, you buy wheat futures. If you believe the price of corn will fall, you sell corn futures. These trades provide sufficient liquidity to the market to allow the fewer pure market participants to have an orderly market. Speculators also aid in the price discovery process through increased liquidity and volume.

For this last group of market participants, commodity risk can be hedged in a variety of ways. At the most basic level, if you maintain a well-diversified portfolio, you will hedge away some of this risk. Stocks and commodities are often negatively correlated (they move in opposite directions), so owning a range of asset types protects against commodity risk. The next choice that is available is to buy interest-rate-sensitive futures. Inflation tends to drive commodity prices higher. Lower interest rates can lead to inflation. As rates rise, inflation may be curbed. Buying fed funds futures, for example, acts as a hedge. As rates rise, the profit from these futures may offset some of the losses in the commodities.

The most direct way to hedge against commodity risk is with options on the futures. If you are long futures, buying puts hedges against a downward price shock. Likewise, if you are short futures, buying calls protects against an upward price shock. Overall, using options to hedge against commodity risk affords you the most ability to make meaningful decisions about structuring the hedge best suited to your needs.

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