A sample hedge

Published on 14 Jul 2023

Let's suppose it is August, and you are a commodity trading company holding storage of Brent Crude you intend to sell at some point in the future. This is known as a long cash (physical) market position. The current cash market price for Brent Crude oil to be delivered in December is $90 per barrel. If the price goes up during that time you will gain. But if the price goes down, you will have a loss. So you are primarily concerned about falling prices during the coming months. To protect yourself against a possible price decline, you can hedge by selling a corresponding number of barrels in the futures market now and buying them back later when it is time to sell your crude in the cash market. The ICE Brent Crude Futures contract has a contract size of 1,000 barrels. For example, to hedge 100,000 barrels, you, therefore, need to sell 100 Brent Crude futures contracts. To be hedged is to have opposite positions in the cash (physical) market and the futures (paper) market. If the cash price declines to $85/bbl, the loss incurred will be offset by a gain from the hedge in the futures market. This risk management strategy is called a short hedge, because of the initial short futures position.