Hedging Toward Future Profits

The commodities/futures markets perform two major functions that often go unappreciated as investors try to make a dollar.

The number one role is price discovery. The markets bring buyers and sellers to determine the equilibrium price based on all of the fundamental information known. Opinions, insight and knowledge are transparent through the price of goods traded. Through this exchange mechanism it is easy to see exactly the price someone is willing to buy or sell.

Beyond determining the fair auction price the market’s second important role allows participants to hedge price risk.

Prices rise and fall with volatility, which makes it difficult to forecast long-term business inputs. Companies large and small can lessen exposure to changing prices by shifting that risk to someone else through the purchase or sale of futures contracts – that’s what hedging is all about. The money made or lost in the cash market for goods is offset by gains or losses in the commodities market.

Every major corporation hedges to stabilize and protect the price of their products. They use futures or options to lock in the costs for a widget, hamburger, soda or even from currency fluctuation on overseas revenue.

Just because the commodity rises, it doesn’t necessarily mean profit margins shrink and are therefore passed on to the consumer. Instead, money can be made in the market to compensate for price moves.

The purchase or sale of commodities contracts locks in price and provides a pseudo insurance mechanism. A true hedge is not designed to make money, but to provide a net zero impact of price movement. This shift of price risk to other parties is the primary function of the commodities marketplace.

My Resource Trader Alert subscribers certainly have enjoyed the satisfaction of big gains when others are complaining about higher commodity prices. The speculation is strictly for profit and the combined power of our trades can help add market liquidity. Additional buyers and sellers enable more efficient trade execution for the all-important economic function of hedging.

Speculation is heavy that the US Dollar will decline. Much of the increase in short dollar positions may be hedges as well. The drop from recent lofty levels adds a bullish undertone to dollar denominated commodities and equity assets. A cheaper US currency gives more buying power to foreign investors.

Typically as the dollar goes down, gold, oil and stocks all rise.

Airlines are highly sensitive to increases in their main cost of fuel. During the previous energy rally of 2008 some went bankrupt because of high prices while others actually made more money on their hedges than from passenger traffic! It continues to amaze that all are not responsible enough to protect themselves with market insurance by hedging.

The price of Jet Fuel, which is not a major trading market, and heating oil, which is, are highly correlated (see the chart below).

Airlines can easily buy HO calls to protect from upside price shocks.

You can hedge your food and energy costs by playing futures or options on these items – and if everything works out the way it should you could have plenty of profit leftover!

Sincerely,
Alan Knuckman
Penny Sleuth

March 22, 2011

Hedging Toward Future Profits was originally featured in the Penny Sleuth. Check out Wall Street’s 5 Most Profitable Penny Stock Patterns Report.

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