On the other hand, when it becomes necessary for you to cover your hedge, if the market has remained steady and is again at 8.00, the two futures transactions cancel themselves without profit or loss. Your original cost of 6.00, therefore, stands as your actual sugar cost at the time of selling (or at the time of delivery). This is 2.00 under the market and you have accomplished your purpose.
HEDGING to establish and limit a loss on an unfavorable purchase.
This operation is identical in its working with the previous example, except that you have a different end in view.
CHART 3
| HEDGING to establish and limit a loss on an unfavorable purchase | ||||||
|---|---|---|---|---|---|---|
| Initial Transactions | Subsequent Transactions | Result | ||||
| Hedge | Condition of market when you "cover" your hedge | Price you pay for futures to cover hedge | Result of hedge and covering operation | Figure actual sugar cost this way | In each case the same | |
| You buy actual sugar at 6.00 but before you have received it (or before you sell it) the price declines to5.00 | You sell futures at 5.00 | It has declined to 4.00 | 4.00 | A profit of 1.00 | Price paid for actual sugar less hedging profit 6-1=5.00 | Your sugar cost is 1.00 above the market |
| You now have your sugar at 1.00 above the market | It has advanced to 6.00 | 6.00 | A loss of 1.00 | Price paid for actual sugar plus hedging loss 6+1=7.00 | ||
| You feel that the market may decline still further and increase this loss, so— | It stands at 5.00 | 5.00 | No profit, no loss | 6.00 | ||
Let us say that you purchase actual sugar at 6.00. If the market declines to 5.00 after your original purchase at 6.00, you have a loss of 1.00, in the value of your sugar. Facing the possibility of a further decline and desiring to limit this loss to 1.00, you hedge by selling futures. In this case you should limit your loss to 1.00 just as effectively as in the previous example you preserved your gain of 2.00, and by the same course of procedure. (See Chart 3.)
By the time it is necessary for you to cover your hedge by buying an equivalent amount of futures, the market may have declined still further, say to 4.00. You sold at 5.00, you bought at 4.00, profit on that operation, 1.00. Subtract this profit from your original cost (6.00) and figure your sugar cost at 5.00. In other words, although the market went still lower, you succeeded in limiting your loss to 1.00, as compared with the market price at the time of the delivery of your sugar (or at the time you sell it). Had you omitted the hedge, your actual sugar cost would have been 6.00, which was 2.00 above the market.
After your original purchase at 6.00, and market decline to 5.00 (at which point you hedged), the market might advance again to 6.00, or remain steady at 5.00, but the operation is no different from that previously described, and you in each case attain the same result.
Buying of Sugar Futures
Refiners do not make a practice of taking orders more than thirty days in advance of actual delivery—but there are obviously times when it is advisable to cover one's requirements for a longer period. A jobber may do this on the Exchange where he will always find a seller at some price for the quantity he desires.