Hedging
Family III · Risk
Not to be confused with arbitrage, position sizing, exposure.
Hedging is the deliberate use of one position to offset the risk of another, so that a move in the market affects the two positions in opposite directions. It does not remove risk entirely; it converts an uncertain outcome into a more predictable one, usually at the cost of giving up some upside. Hedges can be built with futures, options, forwards, or a second cash position in a correlated asset.
How a hedge works
A hedge pairs an existing exposure with an offsetting position whose value moves in the opposite direction. The two legs are usually in the same or a closely related market, so that a loss on one leg is largely cancelled by a gain on the other.
Common forms include:
- Short hedge — selling futures or buying puts against a holding that is already owned, to protect against a fall in price.
- Long hedge — buying futures or calls against a future purchase obligation, to protect against a rise in price.
- Cross hedge — offsetting an exposure with a contract on a different but correlated asset, which introduces basis risk.
Because the offsetting instrument is rarely a perfect match, residual risk remains. That residual is measured as basis, the difference between the cash price and the hedge instrument's price.
Worked example
A producer holds 10,000 bushels of corn and expects to sell in three months. Fearing a price fall, the producer sells two futures contracts (5,000 bushels each) at $5.00 per bushel.
The hedge locked in the original $5.00 price. Had the cash price risen instead, the cash gain would have been offset by a futures loss, leaving the same $50,000. Commission, margin interest and any basis mismatch would reduce or alter that figure.
Costs and limitations
Hedging is not free. Costs vary by market, broker and instrument, and typically include commissions, bid-ask spread, and the funding or margin required to maintain the offsetting position. A hedge also removes the chance of benefiting from a favourable move in the hedged asset.
Basis risk is the main technical limitation: if the cash and futures prices do not converge as expected, the hedge will not be exact. Contract size, delivery months and liquidity can further constrain how precisely an exposure can be matched. Rules on margin, position limits and eligible instruments differ between jurisdictions and venues.
Hedging versus speculation
The distinction rests on the starting exposure. A hedger already holds, or is committed to, a cash position and uses the derivative to reduce its risk. A speculator has no such exposure and takes a position purely to profit from a price move, which increases risk. The same futures contract can serve either purpose; what separates them is whether it offsets an existing exposure or creates a new one.
Often confused with
- arbitrage
- Arbitrage is the simultaneous purchase and sale of the same asset, or economically equivalent assets, in two or more markets to profit from a price difference, with the two legs offsetting so that the position carries little or no market risk.
- position sizing
- Position sizing is the process of determining how many units, shares, or contracts to commit to a single trade, based on account equity, the distance to the protective stop, and the maximum acceptable loss per trade.
- exposure
- Exposure is the total value at risk in a position or portfolio, measured as the quantity of the asset held multiplied by its current price, or as the notional value of a derivative contract.