Managing Your Risk by Hedging Your Investment Dollars

July 4, 2009 by  
Filed under Commodities Trading

Trading in the commodity market is typically influenced by two factors: speculation and hedging. These two factors must generally be considered together, as one never exists without the other. Speculation tends to focus on possible profits in the future, and hedging attempts to protect these profits and reduce possible losses as a defensive move in trading commodities.

Hedging is arrived at with the realization that no investor can correctly speculate future changes in price 100% correctly. Even with the best estimates, timing is an important factor needed in order to capture these profits at the right place.

If you determine that prices are trending upward or downward correctly, you also must guess when to enter and leave the commodities market. Employing a few simple hedging strategies can improve the odds of winning and retaining profits in the long run.

Futures prices and spot markets tend to move in the same general direction. These spot markets are those where the actual physical commodity is bought or sold, and futures are simply contracts for the future delivery of the same commodity. Thus, increasing or decreasing prices in the physical market can influence the investing activities in these futures.

However, there is a difference between spot market pricing and contract pricing. This difference is called the ‘basis’, where basis = cash price – futures price.

When investing in these futures, investors may go short or go long, or mix the two different strategies at different times and between different commodities. ‘Going long’ refers to buying at a lower price, intending to sell the contract at a higher price in the future – much like common stock market investment strategies. ‘Going short’ requires selling a higher-priced contract before buying at a lower future price – much like ‘selling short’ in the stock market.

Going short means that you must borrow the contract for the commodity from your commodity broker before later selling it for profit. This hedging method is beneficial in times when the basis is increasing, and going long is best in markets that show a lowered basis level. It’s important to note that a commodity’s basis may increase or decrease without regard to the direction of actual price; it’s the difference between the two that actually matters.

Using this simple basis calculation can give you an idea of what direction the commodities market may be heading, though it’s never a sure thing. This should simply be used as a tool along with other online commodity trading tools to help you make beneficial trades.

Sometimes, a combination of hedged and unhedged trading is required for a specific commodity. You may want to go both long and short on a basis that is largely unchanged over a specified period of time, purchasing different futures contracts for that commodity.

Novice investors should always seek the help of a commodity broker when entering the commodity trading world, at least at first. As time goes on, you’ll discover the best strategies for making the best bets on these contracts, increasing your net profitability over time.