In investing, a selling hedge refers to a derivative, either a futures contract or an option, that takes a position opposite to an investor’s long position on a commodity. If an investor or commodity producer wants to protect himself from the risk of price fluctuations, he can purchase a selling hedge to offset the risk of downwardly moving prices. Similar to insurance, a selling hedge doesn’t eliminate the chances of an adverse event, but it softens or offsets the impact of the event. If the commodity price goes up, the selling hedge limits the profitability of the commodity investment, but if the price goes down, the selling hedge also limits the degree of loss on the investment.
Unlike insurance, however, the selling hedge is subject to basis risk. This is a situation in which the commodity investment and the hedge do not fluctuate in exactly equal and opposite directions. The imperfect correlation means that the degree of loss in one investment is not fully offset by the gains in the other. Excess gains or losses may occur, due to this hedging strategy.
For example, Joe Citrus, an orange juice producer, will have about 15,000 pounds of orange juice to sell in six months. The current price of orange juice is $1.10 U.S. Dollars (USD) per pound. In order to avoid the risk of a falling orange juice prices, Joe purchases a futures contract for the sale of his 15,000 pounds of orange juice for $1.10 USD per pound. If one month later, the price of orange juice drops to $1.05 USD per pound, Joe suffers a potential loss of $1,500 USD. The selling hedge, however, gains $750 USD, offsetting the loss by 50 percent.
To further the example, imagine that subsequently, a hurricane hits a section of Florida, wiping out a large portion of the orange groves. By the law of supply and demand, the price of orange juice skyrockets to $1.50 USD per pound. Joe’s supply of 15,000 pounds is now worth $22,500 USD, a gain of $6,000 USD over the price two months earlier. The selling hedge takes a loss of $6,000 USD, due to Joe’s agreement to sell the orange juice at $1.10 USD per pound. In this case, the potential gains on paper have been perfectly offset by the losses. Losses on a selling hedge are only realized if the owner sells the contract early, so Joe elects not to sell the contract, holding it until the price of orange juice goes back down.
When implementing a selling hedge strategy, investors must hedge with the correct number of contracts. For example, if the Chicago Mercantile Exchange lists a futures contract for cattle at 45,000 pounds per contract, a rancher with 200 head of cattle at a projected weight of 1,200 pounds each will need to purchase five contracts to hedge more than 90 percent of his pen. Furthermore, the futures contract month should coincide as closely as possible to the actual market transaction date so that the contract can be allowed to expire if the market prices are favorable.