Long Hedge

The long hedge is a hedging strategy used by manufacturers and producers to lock in the price of a product or commodity to be purchased some time in the future. Hence, the long hedge is also known as input hedge.

The long hedge involves taking up a long futures position. Should the underlying commodity price rise, the gain in the value of the long futures position will be able to offset the increase in purchasing costs.

Long Hedge Example

In May, a flour manufacturer has just inked a contract to supply flour to a supermarket in September. Let's assume that the total amount of wheat needed to produce the flour is 50000 bushels. Based on the agreed selling price for the flour, the flour maker calculated that he must purchase wheat at $7.00/bu or less in order to breakeven.

At that time, wheat is going for $6.60 per bushel at the local elevator while September Wheat futures are trading at $6.70 per bushel, and the flour maker wishes to lock in this purchase price. To do this, he enters a long hedge by buying some September Wheat futures.

With each Wheat futures contract covering 5000 bushels, he will need to buy 10 futures contracts to hedge his projected 50000 bushels requirement.

In August, the manufacturing process begins and the flour maker need to purchase his wheat supply from the local elevator. However, the price of wheat have since gone up and at the local elevator, the price has risen to $7.20 per bushel. Correspondingly, prices of September Wheat futures have also risen and are now trading at $7.27 per bushel.

Loss in Cash Market...

Since his breakeven cost is $7.00/bu but he has to purchase wheat at $7.20/bu, he will lose $0.20/bu. At 50000 bushels, he will lose $10000 in the cash market.

So for all his efforts, the flour maker might have ended up with a loss of $10000.

... is Offset by Gain in Futures Market.

Fortunately, he had hedge his input with a long position in September Wheat futures which have since gained in value.

Value of September Wheat futures purchased in May = $6.70 x 5000 bushels x 10 contracts = $335000

Value of September Wheat futures sold in August = $7.27 x 5000 bushels x 10 contracts = $363500

Net Gain in Futures Market = $363500 - $335000 = $28500

Overall profit = Gain in Futures Market - Loss in Cash Market = $28500 - $10000 = $18500

Hence, with the long hedge in place, the flour maker can still manage to make a profit of $18500 despite rising Wheat prices.

Basis Risk

The long hedge is not perfect. In the above example, while cash prices have risen by $0.60/bu, futures prices have only gone up by $0.57/bu and so the long futures position have only managed to offset 95% of the rise in price. This is due to the strengthening of the basis.

Cash September Futures Basis
May $6.60 $6.70 -$0.10
August $7.20 $7.27 -$0.07
Net -$0.60/bu +$0.57/bu +$0.03 (Stengthened by $0.03)

The basis tracks the relationship between the cash market and the futures market. Hedgers should pay attention to the basis when deciding when to enter the hedge as they are said to have taken up a position in the basis once a hedge is in place. See basis.

You May Also Like

Continue Reading...

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results....[Read on...]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount....[Read on...]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time.....[Read on...]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®.... [Read on...]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date....[Read on...]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative....[Read on...]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date....[Read on...]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin....[Read on...]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading.... [Read on...]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator.... [Read on...]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa.... [Read on...]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as "the greeks".... [Read on...]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow.... [Read on...]

Follow Us on Facebook to Get Daily Strategies & Tips!

Futures Basics

Futures Options

Energy Futures

Metal Futures

Grains Futures

Softs Futures

Livestock Futures

Options Strategy Finder

Outlook on Underlying:

Profit Potential:

Loss Potential:


No. Legs:

Risk Warning: Stocks, futures and binary options trading discussed on this website can be considered High-Risk Trading Operations and their execution can be very risky and may result in significant losses or even in a total loss of all funds on your account. You should not risk more than you afford to lose. Before deciding to trade, you need to ensure that you understand the risks involved taking into account your investment objectives and level of experience. Information on this website is provided strictly for informational and educational purposes only and is not intended as a trading recommendation service. TheOptionsGuide.com shall not be liable for any errors, omissions, or delays in the content, or for any actions taken in reliance thereon.

General Risk Warning:
The financial products offered by the company carry a high level of risk and can result in the loss of all your funds. You should never invest money that you cannot afford to lose.

Home | About Us | Terms of Use | Disclaimer | Privacy Policy | Sitemap

Copyright 2017. TheOptionsGuide.com - All Rights Reserved.