Futures For You by Carley Garner
HEDGING PRICE RISK
Is there a way to hedge price risk in the futures market without giving up potential for favorable price movement?
The goal of a perfect hedge is to eliminate the price risk exposure in any particular market. In doing so, however, the end user also gives up any favorable price movement.
Hedging is like any other form of insurance; consumers pay a premium to insurance companies to protect themselves from unfavorable events that will likely never occur. In other words, it isnít possible to enjoy the benefits of protection without giving something up. But that doesnít mean that the hedge itself canít be strategic.
Whether you are a producer or a user of commodities, you can purchase price protection in the form of a long option. For instance, if your business consumes large quantities of gasoline and is vulnerable to higher energy costs, you can purchase insurance against prices moving beyond a certain point by buying a call option. Doing so will be expensive, but it does provide absolute protection above the strike price of the option and leave the door open for falling prices. As appealing as this sounds on paper, I donít believe it to be the best way to hedge. After all, options have a limited life span, and the money spent buying protection when it is not needed will certainly act as a tax against any favorable price movement.