Hedging in Business: How to Hedge Trade

If you are new to trade hedging, it can get confusing. In investments, hedging is an approach where the investor reduces his risks of losing money. Even the biggest corporations do it. 

What is it, and is it legal? How do you even do it? Today, you will learn the basics of hedging and see some examples. In the end, you should decide if this is something that you want to do.  

What Is Hedging? 

Hedging is the act of reducing business risks. A hedge is also a kind of investment that protects another investment if prices fluctuate. Typically, a hedge is something that is the opposite of what you invested in. Some people who bet in an online casino practice this strategy. For example, a person can bet on insurance in a blackjack game. That insurance bet is a hedge. 

Why Do People Hedge? 

A hedge is insurance. As an investor, it is a given that you trust your investment. However, unfortunate things can happen, and your investment can disappear so quickly. To prevent significant losses, companies have to buy “insurance” in the form of a hedge. 

For example, let us say that a company makes corn flakes and depends on corn producers. If the price of corn ever goes up in the future, the company will suffer losses. Why? Because they have to pay more for the price of corn. Then, they cannot sell their cornflakes at a higher price because the market may not reach that price anymore. 

So, what they do is hedge. One common approach is to buy a futures option. In this type of hedging, they will sign a contract with a farmer to buy corn in the future at a specific price. This price is conducive for the cornflake manufacturer’s business. If the price of the corn goes up, the cornflakes manufacturer will pay the agreed-upon price, not the current high price. As such, they “hedged” their investment. They will pay for the corn at a low price and still make a profit. 

Is Hedging Illegal? 

Different countries have different rulings about hedging. In the US, hedging on FOREX is deemed illegal. You cannot buy and sell the same currency in the same trade.

Most of the time, hedging is legal, but there are provisions to it. In Singapore, you cannot buy naked short and hold it until the following day. You have to sell the short on the same day. 

A naked short is a process where you borrow stocks from a broker, believing that the prices will go down. Let us say that you borrowed 100 shares from a broker. At the time of borrowing, at 10 AM, the stock price is $1 per share. You immediately sell the stocks. So now you have $100. 

By 2 PM, the price lowers to $0.50. What you do then is buy 100 shares of that. You will spend $50 ($0.50 per share X 100 shares). Now, you have $50 remaining from what you have sold earlier, plus 100 shares of the stock. Since you owe 100 shares to the broker, you have to give them back.

Again, hedging is not illegal by intent, but many rules differ based on the location and the type of trade you are doing. 

What Are Examples of Hedging?

Below is an example of hedging in the trading business.

Let us say that an oil company, King of Oil Corporation, wants to sell 1,000,000 barrels of oil in December at $50 per barrel. They start production now. Today is January. The $50 price is their goal to sell in December. It is the price by which they can make a profit. 

1 million barrels X $50 = $50 million. They should have $50 million in December. 

However, they know that prices fluctuate. Today, in January, they borrow 250,000 barrels of oil from Queen Oil. The price of oil today is $55 per barrel. Then, they sell this oil to Jack Oil Corporation at $55 per barrel immediately.

Jack Oil paid King Oil. King Oil now has $13,750,000 in cash (250K barrels X $55). However, they owe 250,000 barrels of oil to Queen Oil. The agreement between King and Queen is that King must give back 250,000 barrels of oil to Queen in December. 

Here comes December. King has 1 million barrels of oil and $13,750,000 in cash. The price of oil now is not $55 but $49. King Oil sells the oil for $49 per barrel, so they now have $49 million. It was less than the $50 million that they hoped for. 

They owe 250,000 barrels of oil to Queen. So, they buy 250,000 barrels of oil at $49 each barrel. They spend $12,250,000 for this. Then, they give the 250,000 barrels of oil to the Queen. So, did they make a profit? 

Here is a summary:

• King borrowed 250,000 barrels of oil in January and sold it for $13,750,000.
• In December, they bought 250,000 barrels and paid Queen. They spent $12,250,000, so they still have $1,500,000 from the $13,750,000.
• In December, they sold their own oil for $49 million.
• Total money now is $49 million + $1.5 million = $50.5 million.

When all this thing started, their goal was to make only $50 million, giving them a profit of half a million more.

A hedge in trading is like a strategy when you play roulette online. The idea is to reduce your losses. While one investment is a loss, the other is a win. This approach does not guarantee that you come out on top in the end. It merely reduces your risk.