ADVANTAGES
Understandable:
A hedge is the initiation of an agreement or contract as a temporary substitute for the
purchase
or sale
of a cash commodity at a later date. Ask yourself: am I buying something
or selling something in the future?
Reduced uncertainty:
Fixes your price. Since futures prices tend to move with cash prices, losses in your “cash” transaction should be somewhat offset by a gain in your futures transaction and vice versa.
Delivery:
Enables you to go into the delivery process if there is a problem with your physical transaction.
Low Transaction Costs:
Sometimes just tenths of a cent per unit (lb, gal, bushel, etc)
DISADVANTAGES
Margin Calls:
A favorable move in cash prices is an unfavorable move in futures prices. Resulting margin
calls may be a drain on your cash flow.
No windfall profits:
Cannot profit if “cash” prices move in your favor. Additionally, in a favorable price move in
your cash product, not only will you not be able to participate in windfall profits, you will have
to fund margin calls. Will it tempt you to remove your hedge?
Potential speculative exposure:
An uncertain delivery size may result in unwanted speculative exposure. This is especially true
for producers.
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