The Markets

Welcome to the virtual market, where you can trade all sorts of commodities without any of them changing hands!

Before we dive right into hedging, let me introduce you to a new marketplace. You'll learn much about it in the pages ahead, but it is important to establish up front that hedging will require you to think about more than just the traditional marketplace you've been accustomed to for years.

We'll call the traditional market the physical market. It's where tangible goods move about ... in exchange for cash, of course. It's how most people think about business transactions. You want something I sell? Give me some money and I will give it to you. That's the traditional market at its core.

The new marketplace is a bit different. It anticipates prices in the future and it operates with its own set of rules. Yet it is connected to the traditional market, in that it trades the same commodities. We'll refer to this market as the futures market.

"Commodities?" you ask. Yes, you know them: corn, soybeans, wheat, cattle, electricity, natural gas, crude oil, gasoline, milk, sugar, coffee, gold, silver, copper, and platinum, among others ... the basic building blocks of an economy. Even debt, currency, and weather act as commodities in some businesses. Many companies use commodities, and their prices tend to oscillate based on the laws of supply and demand. Supply and demand are tied to any number of unpredictable factors, either real or anticipated, that can tip the balance. When this happens, price, the great equalizer, moves to reestablish equilibrium.

You will encounter discussions in this book about both the physical market and the futures market for the same commodity. Each market has its own set of prices and its own pool of buyers and sellers. Yet, when these two markets come together, they give birth to hedging. The effective hedger establishes positions of opposing risk in each market. When combined, the risks associated with the positions in the two markets essentially cancel each other out.

A physical market is a collection of buyers and sellers who transact with the express purpose of exchanging a commodity. In a futures market, by contrast, the exchange of a commodity can be a rare occasion. We'll define a futures market as an aggregation of traders who are willing to commit to delivering, or taking delivery of, a specific commodity at some point in the future for a certain price. The futures market will allow them to back away from those delivery commitments before they arrive. Most traders need this flexibility or they won't participate.

The purpose of the futures market is more about establishing future prices than it is about arranging future deliveries. Establishing future prices helps businesses plan, manage risk, and actually transact orders before delivering the products they sell. When a business strategically unites the physical and futures markets as choreographed dance partners, risk has been escorted to the door and invited to spoil someone else's party, if not their bottom line.

Some buyers and sellers of a commodity will participate in both the physical market and the futures market. The futures market, however, will have a much larger pool of buyers and sellers than the physical market, some of whom are not really in a business related to the commodity they are trading. They are trading futures because they think they can make money, whether or not they have an offsetting risk in their portfolio. Yet it matters not. They help others in that market who have a direct business interest in the commodity at hand by providing additional trading partners for them. When there are more traders in a given market, pricing is typically more transparent and more equitable because bidding is more active and more competitive.

The commodity itself may be the only connection between the physical and futures markets that trade it. Yet, sometimes, those markets are tied together in business deals. For example, you may contract with a vendor to purchase a commodity based upon its futures price. When you transact that purchase, you are still trading in the physical market even though your price is predicated on other people's trades in the futures market.

These two markets can also be linked together when a futures contract expires. In order to honor the commitment to deliver under the futures contract, an exchange of the commodity for cash will occur. But, again, this transaction occurs in the physical market, with the futures market merely determining the commodity price.

Although the term "futures market" implies singularity, in reality the market is complex and fragmented. For our purposes, we might rather think of the futures market as a collection of alternatives for trading commodities for future delivery. You'll discover a variety of these hedging tools as you dig deeper into this book.

Now that you've been introduced to the futures market, I'd like you to consider some of the reasons for hedging, and what hedging really is. Then we'll delve into how the futures market works to establish an effective hedge on commodity price risk.

Why Hedge?

Doing nothing is a decision ... sometimes a regrettable one.

What is the purpose of hedging? Why trade in the commodity futures market? Doesn't this activity come with its own set of risks?

The benefit of trading in this market, for those who understand it and use it wisely, is that trading can reduce the overall risk of doing nothing. Effective hedging ultimately protects a business's asset value and net worth. It stabilizes the earnings stream, bringing predictability out of the unpredictable. It can help you stay in business for the long term.

Price Risk Scenarios

Consider the following:

1. A wholesaler purchases a large quantity of gasoline at a fixed price. The market price could decline before he liquidates his inventory. What can he do to protect the value of his inventory, and therefore the value of his business?

2. A heating oil distributor contracts with his customers in June for delivery of heating oil the following winter at either a fixed price or a price not to exceed a certain level. The price of oil may go up, but the distributor's selling price for these gallons cannot,...