You may use a short hedge to lock in the price of an asset and help protect yourself against future falls in value.
To execute a short hedge strategy, you may sell 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 fall more than the price agreed in the 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.
The selling of a futures contract (in this case a short hedge) is usually used to guarantee the price at which you can sell an asset at an agreed price and date in the future. For example, this may 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 selling the futures contract if you expect the price of the underlying asset to fall. Then when the futures contract expires, you can deliver the underlying asset at the price agreed when the contract was signed, rather than at the current (lower price) in the cash market. A speculator would then make a profit on the deal by buying the underlying asset in the cash market at the current lower 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 short futures position sell five contracts of June Crude Oil futures at $100 a barrel. If February Crude Oil futures falls to $85 on delivery date, then the short futures position will gain $15 per barrel. Since the contract size for Crude Oil futures is 100 barrels, the trader will achieve a profit of $15 x 100 x 5 = $7,500.
The potential for gains for selling contract will be limited because in theory the cost of the underlying asset can only fall as low as zero. The potential for losses, however, are unlimited because the underlying value of the asset could rise infinitely higher.
Example: If February Crude Oil futures traded at $150 on delivery date, then the seller of the future would have to enter the market to buy the underlying asset and would suffer a loss of $150 x 100 x 5 = $75,000. The loss is big but of course could be worse depending on how much the value of the barrel rises.
CLOSING OUT FUTURES CONTRACTS
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.
SHORT HEDGE EXAMPLE
In September, an orange juice-making company plants enough orange trees, which will be ready for harvesting by late February and delivery in March, to deliver 1,000,000 lbs of orange juice. The total cost of plantation and harvesting the crops is $1,105,500 or $1.10 per 15,000 lbs.
In September, March juice frozen orange futures are trading at $1.40 per 15,000 lbs. The juice-making company wishes to lock in this selling price. To do this, it enters a short hedge by selling some March orange futures.
With each orange futures contract covering 15,000 lbs of frozen orange juice, the company needs to sell 67 futures contracts to hedge their projected 1,000,000 lbs output.
By mid-February, the orange tree crops are ripe for harvesting. The price of frozen orange in the cash market, however, has since fallen to $1.00 per drum due to a better than expected harvest, which has seem the market flooded with quality orange juice. The prices of March orange futures have also fallen and now trade at $1.25 per tree.
CASH MARKET LOSS
If the juice-making company were to sell 1,000,000 lbs of frozen orange in the cash market it would make: 1,000,000 x $1 = $1,000,000. Therefore the crop has actually lost the company $105,500 because it cost $1,105,500 to plant and harvest the orange trees.
But that has been offset because the company took out a short hedge.
FUTURES MARKET GAIN
The value of the orange futures sold in September was 67 contracts x $1.40 per contract x 15,000 lbs per drum = $1,407,000. But the value of the wheat futures Purchased in March was 67 contracts x $1.25 per contract x 15,000 lbs per drum = $1,256,250. Therefore the net gain in the futures market is $1,407,000 - $1,256,250 = $150,750.
The gain in the futures market ($150,750) has therefore offset the loss in the cash market ($105,500). Net profit is £55,250.