What Exactly is a Long Hedge?
A long hedge represents an essential strategic tool aimed at achieving price stability on necessary purchases through futures positions. It’s a favorite among manufacturers and processors looking to mitigate price fluctuations and secure their required inputs at predictable costs. By entering into futures contracts, these companies can stabilize purchase prices throughout the year, ensuring a continuity of operations and budgeting.
Known alternatively as an input hedge, buyers hedge, buy hedge, purchasers hedge, or purchasing hedge, the long hedge stands as a versatile mechanism designed to protect against unwanted price changes.
Grasping the Concept of Long Hedges
The essence of a long hedge lies in its efficacy as a cost control strategy for entities anticipating future commodity purchases. Here’s how it works: a company, foreseeing the necessity to buy a certain commodity, takes a long futures position to lock in current prices for future dates. This effectively secures the purchase rates against potential market fluctuations.
The buyer’s stance in a long position is straightforward: they’re betting on the price elevation of the commodity in the coming times. Should the commodity price climb, the resulting profit from the futures position offsets the increased procurement cost, maintaining financial balance within the organization.
A Real-Life Example of Long Hedge
Imagine it’s January, and an aluminum manufacturer needs 25,000 pounds of copper to fabricate aluminum and deliver a finished product by May. The current spot price stands at $2.50 per pound, while the May futures price is $2.40 per pound. To safeguard against price fluctuations, the aluminum manufacturer enters a long position on the copper May futures contract.
Their main goal is to size this contract appropriately to match their needs, establishing what’s known as the hedge ratio. For instance, if they hedge half the necessary purchase, the hedge ratio becomes 50%. When May arrives, if the spot price of copper exceeds $2.40 per pound, the manufacturer gains from the futures contract, compensating for the increased price.
Conversely, if copper’s spot price dips below $2.40 per pound, the manufacturer experiences a minor loss on the futures contract, yet they save overall by purchasing copper cheaper than anticipated.
Comparing Long Hedges to Short Hedges
Basis risk often complicates the full offsetting of pricing risk. However, a high hedge ratio in a long hedge can significantly reduce it. Unlike long hedges, short hedges serve the opposite function—they protect sellers of commodities by fixing the sale price in advance.
Viewed as a form of financial insurance, both long and short hedges involve setup costs but offer substantial savings during adverse price movements, underscoring their value as risk management tools.
Long hedges provide a structured pathway for businesses to navigate the volatility of commodity markets. By securing future costs today, they offer peace of mind and a steady financial outlook.
Related Terms: futures contracts, volatility, cost control, commodity, hedge ratio, short hedge.
References
- University of Missouri Extension. “Long Hedge Example With Options”.
- FasterCapital. “Hedging Strategy: Mastering Hedging Strategies: Longhedge Essentials”.
