Suppose you have bought sugar, have not hedged against it, and have seen it advance. Finally you have said, "I think sugar is about as high as it is going. I am going to sell against that to protect that profit."
On the other hand, the reverse might be the case. You might find the market going down, and say, "The market is going lower. I want to hedge against that, and limit my loss to a definite amount."
CHART 2
| HEDGING to protect a gain on a favorable purchase of actual sugar | ||||||
|---|---|---|---|---|---|---|
| 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 advances to 8.00 | You sell futures at 8.00 | It has declined to 6.00 | 6.00 | A profit of 2.00 | Price paid for actual sugar less hedging profit 6-2=4.00 | Your sugar cost is 2.00 under the market |
| You now have your sugar at 2.00 under the market | It has advanced to 10.00 | 10.00 | A loss of 2.00 | Price paid for actual sugar plus hedging loss 6+2=8.00 | ||
| You feel that the market may recede and eliminate this gain, so— | It stands at 8.00 | 8.00 | No profit, no loss | 6.00 | ||
In both of these cases, the operation is relative. If a man has a profit, let us say 2¢ a pound, and he hedges, he maintains his profit of 2¢ a pound as compared with the market at the time of delivery, or at the time when he expects to sell this sugar, regardless of whether the market is higher or lower.
In the same way, conversely, if he has a loss on his sugar of 2¢ a pound, by hedging he can limit that loss to 2¢ a pound, even though the market goes still lower. In other words, his sugar cost at the time of delivery, or at the time when he expects to sell the sugar, will be about 2¢ above the market price, whether the market is higher or lower.
We shall assume that you have bought from a refiner through your broker a supply of actual sugar at 6.00. While your sugar is in transit or before it has been shipped by refiners, the market advances to 8.00, at which point it apparently is steady. You now have a theoretical gain of 2.00—that is, if you were to sell your sugar at once, you would have an actual profit of 2.00; but you do not sell because your sugar is in transit or you need it for your trade. However, you do want to preserve and protect this favorable position of having your sugar 2.00 below the market at the time you want to sell it. So you sell the same quantity of futures on the Exchange at 8.00.
Three things may occur—the market may decline, or it may continue to advance, or it may remain steady. You have accomplished your purpose in any case (see Chart 2).
By the time you sell your sugar (or at the time of its delivery) it becomes necessary for you to cover your hedge and if the market has declined from 8.00 (at which point you hedged) and stands at 6.00 again, your hedging operations considered alone would net you an actual profit of 2.00. Your original sugar cost was 6.00. Your profit on your hedge was 2.00, so that you would figure your actual sugar cost at 4.00. You would have accomplished your purpose of getting your sugar 2.00 under the market at the time of selling it (or at the time of its delivery). That is, your delay in selling your sugar has cost you practically nothing, even though the market has declined.
If the market has advanced to 10.00, when it becomes necessary for you to cover your hedge (at the time of selling your sugar or when it is delivered) your hedging operations considered alone would net you a loss of 2.00. You would buy in futures at 10.00, which you sold at 8.00. Your original sugar cost was 6.00, your loss on your hedge was 2.00, so that you would figure your actual sugar cost at 8.00. But the market at that time was 10.00, so that you have accomplished your purpose of getting your sugar 2.00 under the market at the time of selling it (or at the time of delivery). In other words, you would make the same profit as though you had re-sold your sugar to second-hands originally, instead of hedging, but had you followed this course, you might not have had sugar in stock for your regular trade.