If the price goes up, there is a speculative gain—the sugar is worth more. But if the price goes down, the buyer sustains a speculative loss.
The measure of protection afforded by the Exchange will appeal to those jobbers who wish to reduce the speculative element in their business.
In the example immediately following, as in all others, we have not taken into consideration the difference between the Exchange quotations and the Seaboard Refiners' quotations, which is explained on page 38. This would simply inject an unnecessary complication, and would be of no particular advantage for purposes of illustration.
Suppose you should buy through your broker from a refiner, for prompt shipment, an amount of actual sugar at 6.00, which you plan to sell within a short time after its receipt. Instead of worrying about subsequent sugar price fluctuations, you simultaneously hedge this purchase by selling futures in the same amount on the Exchange. The price at which you buy actual sugar and the price at which you sell futures should be relatively the same, since Exchange prices generally reflect refiners' prices.
You should be able to figure the cost of your sugar at about the market price at the time it is received or sold. (See Chart 1.)
If the price of sugar should go down to 4.00 at about the time when you sell it, your actual sugar, for which you contracted to pay 6.00, would be worth only 4.00; but you would then buy to cover your futures sale, making 2.00 on this transaction, which, subtracted from the price you paid (6.00), brings the cost down to the market price of 4.00. In other words, you have accomplished your purpose of being able to figure your sugar cost at the market price at the time when you received it (or at the time you sell it). That is, although every pound of actual sugar was sold at a loss, this loss was balanced by the profit from your hedge.
If, on the other hand, the market should advance to 8.00 after your original purchase and hedge at 6.00, the value of your actual sugar would be increased by 2.00. You would then buy futures at 8.00 to cover your short sale at 6.00, netting a loss thereby of 2.00. This loss would be added to your original cost of 6.00, making your actual sugar cost 8.00, which is the market price at the time. Had you omitted the hedge, your sugar would have cost you only 6.00, but, in this example we are assuming that you would sell only when you were willing to figure your sugar cost at the market price. This you have accomplished by foregoing the speculative profit you might have made in favor of your normal jobbing profit.
If the market should remain relatively stable you would buy to cover your hedge at approximately the same price as you sold for, your gain or loss being practically nothing. In other words, you would obtain sugar at the market price, which is the purpose in this kind of a hedge.
HEDGING to protect a gain on a favorable purchase of actual sugar.
All sugar buyers have had the experience of buying actual sugar, only to see it advance or decline before they have disposed of it. How to protect the gain, or minimize the loss, is described in the two hedging positions which we now discuss.