Posted By: Ilan Levy-Mayer Vice President, Cannon Trading Futures Blog
Many investors are in the futures trading market for one reason: to make a profit. This process, known as speculating, is fairly straightforward as the investor is looking to take a risk on certain markets to try and predict the rise and fall of costs and volatility. Conversely, however, there is another strategy that is quite the opposite. Rather than entering into the futures market to take risks and make money, many investors will participate in a futures trading strategy known as hedging to keep their costs low, and their assets safe.
What is Hedging?
Hedging is a process done by either a producer of a commodity or a company that relies on a certain commodity to operate. The two parties will sign a futures contract, or a prior arrangement to buy or sell at a set time in the future for a fixed price. Commodities producers and business owners alike engage in this practice in order to offset their risk exposure and protect themselves from any fluctuation in price. It is a way for business owners to mitigate the fear of the unknown, especially for more volatile assets such as wheat, soybeans, and other agricultural commodities.
In the example of agriculture, a farmer may be interested in participating in a futures contract to ensure a profit. The farmer can never be certain that the price of his commodity will stay the same at harvest as when he originally planted them. In this time, their value may decline and he will lose money on the sale. Conversely, a business relying on these crops will not want to risk that their prices will go up the next time they need to purchase them in large quantities. The two parties will mutually agree on a shared price that is in both of their best interests to mitigate risk in what is known as a long term cash position or a hedging strategy.
Disadvantages and Risks of Hedging Strategies
When hedging with a futures contract, investors must keep in mind that it is exactly that, a contract. Remember, no one has ever gone into a long term cash position for a futures contract with the intention to get rich — Quite the opposite. Hedging strategies are intended to be a safety net in case of drastic price increases on a commodity you are buying or selling. With this in mind, it is still easy to lose out on money using this strategy. An investor may set the cost of a hedge and wind up paying more than it would have cost to just buy the commodities outright in real-time. When entering into a long term cash position, the investor must weigh if the set price can justify the savings they might see, and act accordingly. Like having insurance, hedging is a method that investors use to avoid uncertainty, and avoid large losses if unfortunate or unfavorable circumstances were to occur. Like insurance, however, it is not uncommon to end up paying more money having it and not needing it, but better safe than sorry!
Getting Started With Hedging
Even if you do not plan on participating in a hedging strategy and the inverse short term cash position, or speculating, is the direction you choose — understanding this process is an essential skill for any investor. Many large entities like airlines, oil companies, and investment funds will use this strategy to preserve costs in the event of high fluctuation rates and foreign exchange rates. As an investor, you will be better equipped to analyze and fully understand the investment strategies that these large companies are taking. Whether you are using it for yourself or just becoming a more well-rounded investor, a firm understanding of this process will help you to understand the market.
Futures trading is an inherently risky practice, and by nature is based solely on predictions alone. While an investor can never be completely certain which way the market will go, hedging can be a useful tool in keeping their assets and commodities protected. Avoid missteps that can lead to overabundances of your investment, a shortage of your investment, or the costly mistake of losing more money than you initially put in; trust the professionals at Cannon Trading. Cannon Trading will help you to get started by partnering you with a professional futures broker. Our professional team members will help to advise you on which platforms and which investments are right for you, to help get you started investing in the futures trading market. We will help to advise you on all of your trading needs and questions when they arise with our extensive background and knowledge of futures contracts and trading. Don’t go it alone, start your commodities trading journey with expert assistance from Cannon Trading.
Disclaimer – Trading Futures, Options on Futures, and retail off-exchange foreign currency transactions involves substantial risk of loss and is not suitable for all investors. You should carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources.