By Wichard Cilliers, Director & Head of Market Risk


Hedging is a crucial strategy in commodity trading that involves a future commitment to buy or sell a set quantity of a commodity at a set price. This commitment helps manufacturers ensure they have the necessary commodities for production and sellers know they have a buyer for their crops. By reducing risk for both buyers and sellers, hedging plays a vital role in stabilising the commodity market.

Why Hedge?

Hedging involves taking a futures position that is equal and opposite to a position held in the cash market. The primary objective is to mitigate the risk of adverse price movements. By hedging, commodity traders can guarantee a minimum profit for each transaction without exposing themselves to the risks associated with the physical market.

Hedging works effectively because futures prices and cash prices are highly correlated. For instance, a coffee producer faces the risk that the cash price will decrease before the beans are harvested and sold. Selling coffee futures mitigates this risk. If the cash price does decline, the futures price will also decline, allowing the producer to buy back the futures contract at a lower price, generating a profit that can be applied to the revenue from selling the coffee on the cash market, thereby mitigating the cash price decrease.

Fluctuating commodity prices can lead to cash flow fluctuations, forcing companies to undertake short-term financing arrangements to address liquidity deficits, increasing costs. Hedging commodity price risk minimises these cash flow fluctuations, insulating the company from the impact of volatile price movements.

Understanding Commodity Price Risk

Commodity price risk is the financial risk companies trading commodities face due to fluctuations in commodity prices, usually driven by external market forces. Volatility in commodity prices affects different players in different ways. A fall in commodity prices can decrease sales revenue for producers, reduce their profits, and decrease input costs for manufacturers, increasing their profits. Commodities held as inventory lose value if the price goes down and gain value if the price increases.

On the other hand, a rise in commodity prices increases revenue for producers if companies are willing to pay the higher price. The entire market could grow as new entrants get in on the higher-value commodity. At the same time, manufacturers using the commodity will have lower profit margins since their costs have gone up.

Futures Contracts for Hedging

Futures contracts are traded on organised exchanges. Producers, users, and processors can establish prices before trading commodities.

Futures contracts have standardised terms established by the exchange, including the volume of the commodity, delivery months, delivery location, and accepted qualities and grades. The contract specifications differ based on the commodity being traded. This standardisation makes it possible for many participants to trade the same commodity, making the contract more useful for hedging.

A farmer is an example of a hedger. Farmers grow crops and carry the risk that the price of their crop will decline by the time it is harvested. Farmers can hedge against that risk by selling futures, which can lock in a price for their crops early in the growing season. Then, if the price does decline, they can still secure a profit on their crop.

Very few futures contracts are ever delivered upon, as they are typically liquidated via offset before the delivery date.

Options Hedging

Options are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset once its price reaches a certain level—known as the strike price—at or before an expiry date.

There are two types of options:

Treasuryone-south-africa-erp-bank-tms-connectivity-step-1Call options give the holder the right to buy an asset, but not the obligation. You buy a call option if you believe the market price will rise from its current level, and you sell a call option if you think it will fall.

Treasuryone-south-africa-erp-bank-tms-connectivity-step-2Put options give the holder the right to sell an asset, but not the obligation. You buy a put option if you believe the market price will fall from its current level, and you sell a put option if you think it will rise.

Put options are more commonly used in hedging strategies, as opening a position to sell the same asset you currently own can help prevent downside risk.

Examples of Hedging

Futures Contract

A trader buys cocoa beans at a specified price for delivery in five months and sells an equivalent quantity in futures contracts. If cocoa prices go up, the trader loses on future sales but earns a compensating profit from the gain made on purchasing the cocoa beans. Later, when the trader finds a buyer for the cocoa, they buy back their short-term contracts while selling the cocoa, thereby lifting their hedge. The trader does not care how the market behaves between when the cocoa beans are purchased and when they are sold.

Options Trading

A producer expects a crop of 100 tons of cocoa beans to be shipped six months from now. The market has been in a downward trend. The producer sells the crop at the current market price to ensure it receives today’s price. However, they don’t want to lose out if the market turns around, so they buy 10 call options at the current price. If the market continues to fall, the producer lets the options expire and receives the original sale price for the crop. If the market goes up, they sell the crop at the original contract price, call in the 10 contracts at the original price, and sell the 10 at the now higher market price.

Hedging helps producers and buyers protect themselves from fluctuations in commodity prices and enables them to lock in a worst-case scenario price to reduce potential losses, benefiting both producers and buyers.