Understanding Hedging - I

A farmer's wheat crop was almost ready for harvesting.

Almost...but not yet....

He knew that it would take around 2 weeks for the crop to be fully ready, cut, thrashed and transported to the market.

"If only I could sell my entire crop today!", the farmer thought with a sigh.

Reason?

The price for wheat in the market that day was "mouthwatering and unsustainably high".

This was probably due to the reason that the harvesting season had just started and the demand in the market was much higher than the amount of crop arrival in the Mandi in those initial days.

"I know I can't sell today. Can't do anything about the missed opportunity!" the farmer consoled himself.

If only he knew that he could ensure today's price without selling his crop - by just selling wheat futures lots in the commodity market!

(One of the reasons why farmers and their families should be educated!)

If the quantity of his crop was expected to be equivalent to 10 lots of wheat futures, then he should have shorted (sold) 10 lots of wheat futures in the commodity exchange.

If after 15 days, when his crop would have entered the market, the price of wheat falls, his spot loss will be offset by his equivalent profit in the futures lots (because he had shorted the lots).

(Similarly, if the price of wheat in the market rises, his spot profit would have been offset by his equivalent loss in the futures lots.)

This way the farmer can rest with peace of mind till his crop is actually ready for sale!

He is assured of today's excellent price and protected against wild unexpected swings in the price.

Similar situation generally occurs for medium term investors who don't want to sell the stocks they have in their portfolio before 365 days (to become eligible for long term capital gains tax).

But they are often faced with a dilemma when the price of the stock in their portfolio has already run up a lot, is severely overbought and is likely to fall.

In this case, the investor sees no fun in saving the tax while losing the earning (probably much more than the tax savings)!

Another situation may arise when the investor wants to hold the stock in anticipation of dividend or bonus shares etc. but is afraid of profit booking of market crash.

Fortunately, he has the option to short (sell) equal lots of stock futures. This way any decline in the spot price of his stocks will be offset by the increase in the value of the shorted lots of stock futures.

This is known as Hedging against future loss by locking the profits today!