How does a long hedge Futures strategy work?
You may use a long hedge to lock in the price of an asset and protect yourself against futures spikes in value.
To execute a long hedge, you may buy a futures contract to hedge or speculate on an equity index, commodity or currency if you think the cash market price of that asset will rise higher than the price agreed in futures contract by the expiration date.
If your expectation is correct, you may realise a positive return. If you’re wrong, you can try to trade out of the futures contract, providing you can find a willing counterparty, or face the loss of the difference between the price you agreed in the contract and the actual price of the asset in the cash market when the delivery date arrives.
Buying of a futures contract (in this case a long hedge) is usually used to guarantee the price at which you can buy an asset at an agreed price and date in the future. For example, this mey be useful if you are a company which trades in markets overseas exposed to fluctuation interest rates and resulting exchange rate volatility.
You may consider buying the futures contract if you expect the price of the underlying asset to rise. Then when the futures contract expires you can accept delivery of the underlying asset at the price agreed when the contract was signed, rather than at the current higher price in the cash market. A speculator would then make a profit on the deal by selling the underlying asset in the cash market at the current higher price.
Example: February Crude Oil futures is trading at $100. Each futures contract covers 100 barrels of Crude Oil. A futures trader entering into a long futures position buys 5 contracts of June Crude Oil futures at $100 a barrel. If February Crude Oil futures rallied to $125 on delivery date, then the long futures position will gain $25 per barrel. Since the contract size for Crude Oil futures is 100 barrels, the trader will achieve a profit of $25 x 100 x 5 = $12,500.
The potential for gains for a buyer of futures contract can be unlimited because in theory the cost of the underlying asset can go keep going infinitely higher. The potential for losses, however, are limited because the most the worst that can happen is that the underlying value of the asset could become worthless.
Example: If February Crude Oil futures traded at $0 on delivery date, then the buyer of the future will suffer a loss of $125 x 100 x 5 = $62,500. The loss is still big but the value of the barrel cannot be less than zero.
CLOSING OUT A FUTURES CONTRACT
Often investors who enter into futures contracts do not hold those contracts until delivery date and instead close out a futures contract at any time prior to the contract's delivery date, subject to a willing counterparty being found.
You can close out a futures contract in four ways:
- Offset is the transaction of a reversing trade on the exchange. (Most futures are closed out by offset.)
- Cash settlement is simply the holding of a cash settled future until expiration.
- Delivery is the holding of a physically settled future.
- Exchange for physicals (EFP) is a form of privately negotiated physical settlement of long and short futures positions held by two parties.
LONG HEDGE EXAMPLE
British Company A has agreed to sell a shipment of computers to American company B in six months’ time and receive payment in dollars. At the current exchange rate of $1.75 to the pound the deal will net the British company $35,000 or (£20,000). The British company is worried about the exchange rate fluctuating and the potential for sterling to strengthen against the US dollar as interest rates rise in Britain, therefore de-valuing the dollar and depreciating the value of the deal. Sterling/dollar (cable) futures for settlement in February are trading at $1.77.
The British company therefore enters into a futures contract to buy sterling and sell £35,000 dollars at an exchange rate of $1.77 in February.
As the British company expected interest rates in the UK do indeed rise. The value of sterling appreciates to $1.84 come February.
American company A still pays the British company $35,000. But because the British company took out the futures contract it will exchange the $35,000 at 1.77, rather than the 1.84.
That means the UK company will receive the sterling equivalent of $35,000 / 1.77 = £19,774.01.
If it hadn’t taken out the futures contract it would have exchanged $35,000 / 1.84 = £19,021.74.
By using the hedge the company has made £752.27 on the deal more than it otherwise would have done.