Last Updated on 21 September, 2020 by Therobusttrader
Hedging is a form of risk management technique where some of the risks that a position carries are offset by entering a position in another, uncorrelated market.
You hedge with futures by finding a futures contract that has a negative correlation to your first market. Then you calculate the position size depending on the contract size and enter with the appropriate number of contracts. Then, once you’re in the position, you need to make sure to stay in the same contract by rolling over the futures contract.
Futures contracts, which are agreements to buy or sell a given quantity of an asset at a set date and price, are some of the most commonly used securities for hedging. In fact, futures contracts were invented for risk management purposes, when farmers started to offset their risk by selling a futures contract to speculators. In effect, this gave speculators the opportunity to speculate in the future developments of price, while the issuer of the contract was guaranteed the amount stated in the contract.
In this article, we’re going to look at how corporations today use futures contracts to hedge risk, and how you could go about if you want to do the same.
How and Why Do Companies Hedge Using Futures?
A company that operates by purchasing and/or selling some sort of commodity and knows the amounts and dates that the purchases will be made, can choose to use the futures markets to ensure supply at a given price. The reason is that companies usually want predictability and to know what their expenses are going to be, in order to maintain profitable.
For example, if an airline company operates with a very small profit margin, the price of fuel is an important factor when it comes to setting the ticket prices. And since tickets are booked in advance, the airline company must be very observant of the developments on the fuel market, not to incur heavy losses.
Now, in response to challenges like these, companies can decide to use futures, or forward contracts to hedge their risk.
In essence, this means that the airline company goes to the futures market to offset any outsize movements in fuel prices. Since standardized futures that track airline fuel aren’t available, they will choose a market that closely follows the price of airline fuel. They decide to go for crude oil, and go long the number of contracts that represents the amount of fuel they’ll use for the coming period.
As such, any increments in the price of oil will make the long position in the futures contract profitable, while the operating expenses of the company should increase the same amount as that profit.
In the same way, a decline in the price of oil would mean that the futures position produces losses, while the operating expenses get lower.
Challenges With Using Futures For Hedging
Having a perfect hedge is very hard or impossible. There are several aspects that play a role, and here are a few of them:
1.The Term Structure of Futures Contracts
Since futures contracts are agreements to buy or sell an asset at a future time and date, the price of the contract isn’t only a representation of the price of the underlying, but also things like storage costs and the market’s expectation of the price on the delivery date.
As such, the futures contract might be trading at a slightly higher price than the spot price, and then fall as it nears the delivery date.
What is described here, is a market in contango where faraway futures contracts are more expensive than contracts with shorter time to delivery. The opposite of this could also hold true, which would mean that the futures contracts with a longer time to delivery would be cheaper than the spot price, and appreciate as the delivery date comes near. This is called backwardation.
Backwardation and contango mean that the futures contract won’t exactly follow the movements of the underlying asset, and such distortions make hedging a bit less precise.
2. The Commodity Isn’t available as a Futures Contract.
As we covered in the airline example, there aren’t futures contracts for every type of commodity. Sometimes companies will have to go for the next best solution, which means using futures contracts in a correlated asset.
How Can You Hedge Using Futures?
As we explained earlier, it’s common for companies to use futures to hedge against unexpected price fluctuations in the assets they use for their daily operations. However, still being a viable option it’s less common that individual investors or market players use futures to hedge their positions. For those purposes, options contracts are better in most cases.
However, if you still want to use futures to hedge your positions, this is how you go about.
- Identify the Futures Contract
- Get the value of the contract
- Maintain the position (rollover)
1. Identify the Futures Contract
As there aren’t futures contracts for all securities, you will have to either use a market that’s tracked by a futures contract, or find a correlating futures market.
Now, in case you’re trying to use a stock for hedging, it could become a little difficult. Far from every stock can be accessed through a futures contract, and a broad market index is probably not what you’re looking for.
However, most of the bigger stocks can be reached through futures contracts. Those contracts are usually referred to as single-stock futures.
2. Get the Value of the Contract
A futures contract is an agreement to buy or sell a predetermined amount of the underlying at a future price and price. As such, buying a single futures contract worth 100 shares means that you commit to buy 100 shares when the future contract expires.
However, you don’t have to pay the cost up-front. Instead, there is an initial margin requirement that needs to be met, meaning that you need to keep a certain dollar amount in the account to buy a futures contract.
This initial margin requirement is many times lower than the actual value of the underlying that is to be delivered on expiry. As such, you’re trading on margin, and may take positions that exceed your account balance.
Therefore it’s paramount to not calculate the number of contracts to buy based on initial margin, but on the value of the contract’s underlying.
In our article on futures contracts, we cover this in greater detail.
3. Maintain the Position
Since futures contracts expire, you must roll-over your positions before expiry not to take actual delivery of the underlying( if the contract is physically settled). This means that you close your position in the current contract, and open a new position in the coming one.
Most brokers, however, will bring you out of the contract before you have to take delivery or deliver the asset you traded. Most times the charge a small fee for this.
If you want to know more about rolling over a futures contract, have a look at our article on how to roll over a futures contract.
The most common scenario when futures are used for hedging is a company that wants to lock in prices of commodities it depends on for its daily operations.
However, retail investors could use futures for the same purposes, but need to be aware of things like rollover and contango and backwardation