Please explain "hedging" to me like I'm a 1st grader

Hedgers:

Hedgers are looking for some measure of price certainty. Commodity hedgers – people who trade agricultural products, energy products or metals, for example – typically are involved in commercial interests that will either produce, process or utilize the commodity they are trading. Hedgers of financial futures are typically in businesses that depend upon interest rates, foreign exchange rates, or stock index levels, such as banking or pension fund management.

Cattle ranchers, for example, may fear that cattle prices will decline before they bring their animals to market. To protect themselves, they decide to sell futures on live cattle that will expire at approximately the same time they expect to deliver their cattle to the market, and at the price they are hoping to get in the cash market. If cattle prices do go down, the ranchers can still make money on their future’s positions, which will hopefully offset the reduced price they receive for their cattle.

Example:

June 1st - Cash Market - Cattle is $0.87/lb.
Futures Market - Rancher sells one CME October Live Cattle futures contract at $0.89/lb.

October 1st - Cash Market - Cattle prices have dropped to $0.77/lb. Rancher sells cattle at market price of $0.77/lb.
Futures Market - Rancher buys back the October contract at $0.79/lb.

Outcome - Cash Market - Rancher receives $0.10/lb less than desired price.
Futures Market - Rancher sold futures at $0.89/lb. Rancher bought back futures at $0.79/lb.

Calculations - Cash Market - Price rancher wanted ($0.89/lb. x 40,000 lbs. = $34,800
Futures Market - Rancher sold futures at $0.89/lb. Rancher bought back futures at $0.79/lb.

Actual price received: $0.77/lb x 40,000 = $30,800

Cash Market - Actual price received is $4,000 less than the rancher wanted.
Futures Market - Futures Profit = $0.10 x 40,000 = $4,000

Net Result - Rancher's loss is the cash market is offset by the gain in the futures market. Hedging strategy succeeded.

*Note: The futures price is slightly higher than the cash price to accommodate costs of shipping and delivery of cattle.

This takes into account that the rancher has a decent ability to understand his business and a reasonable ability to read price direction, either seasonally or technically. Ranchers also will speculate in the grain markets to to offset as much feed costs as possible. Some of the best managers of feedlots will make enough in their speculations to totally offset their feed costs and even make a little extra.
 
Educate yourself if you are going to play a game of chance. Hedging a cash commodity with a futures contract is to lock in prices to protect the owner of the cash commodity from a negative price change until the contract calls for delivery of the commodity.

The cash commodity merchant that enters into a contract to deliver a product in the future at a certain price would be at risk if said merchant sees the cash product rise in price before the cash product was secured to fullfill the contract. To protect the company the merchant would enter a long contract until he secured the cash product from a price rise. In that situation the merchant would secure the product and then lift the long hedge and deliver the product at the contracts price.

There are numerous examples where merchants will go long or short and the same for the users of the products.

Buy the book and educate yourself about how the futures industry has been around for a long time and worked just fine. There is no one or no gov or merchant that can finance a 15 BILLION corn crop each and every year without the futures industry. corn, wheat, soybeans, coffee, prunejuice etc, etc..........that gives you a small idea about how HUGE the indudtry really is and hpow important a service us small time speculators provide.

http://www.amazon.com/Understanding-Futures-Markets-Robert-Kolb/dp/1405134038

PS: A texas hedge is to be on both sides of a hedge with equal amounts. LOMG cash and LONG futures. A price decrease and the hedge will wipe him/her out. haha

PSS: in the mkts, commercials, users , speculators all have different uses of the mkts at different times. A commercial might be lifting some hedges on now covered contracts and turn right around and get back long or short on others. Just a small example why watching volume in futures trading is foolish. Is the volume going up or down because someone is lifting a long or short hedge or are they initiating a short or long hedge? Good luck figuring that out. Watching price is all you as a speculator need. Do not try to outguess the other players without seeing their cards. :)
 
Sometimes, I go long and short same stock same time. Ill buy the trend. If market turns and makes stock head the other way, Ill buy opposite direction to stop my losses. When market looks to reverse again, Ill dump one direction so I can resume profit increase. This way I get maximum profit without executing 2 trades to reverse direction, and another 2 to resume initial direction. Dont forget the loss of the gap profit as you enter all these trades. This works great while we are in a trading range like right now. But not good strategy when we finally start the breakout up. But that wont be for awhile.
 
Here's another way to look at it. Assume you are taking a position in a security affected by mulitple risks. You want exposure to some component of the risk - either you think you make money over the long term from exposure to this risk or it is necessary for a bet you want to make. You don't want exposure to the other risks. Hedging lets you decrease exposure to the risks you don't want.

For example, you buy a particular corporate bond because you think credit spreads are too wide and will come in. But you are exposed to the overall level of interest rates, which you don't like. Credit spreads could come in like you think, but you might still lose money if interest rates rise. So you short some treasury futures as a hedge. Then you have the credit exposure required for the bet you want to make, but you reduce the risk the exposure to overall rates you don't like.
 
this sounds nice on paper, but it doesn't work out when you try to implement it. you don't know how much treasury to short for that hedge to work out as intended. you may build fancy models, but in the end you're just making assumptions on assumptions on assumptions on the final input.


Quote from black diamond:

Here's another way to look at it. Assume you are taking a position in a security affected by mulitple risks. You want exposure to some component of the risk - either you think you make money over the long term from exposure to this risk or it is necessary for a bet you want to make. You don't want exposure to the other risks. Hedging lets you decrease exposure to the risks you don't want.

For example, you buy a particular corporate bond because you think credit spreads are too wide and will come in. But you are exposed to the overall level of interest rates, which you don't like. Credit spreads could come in like you think, but you might still lose money if interest rates rise. So you short some treasury futures as a hedge. Then you have the credit exposure required for the bet you want to make, but you reduce the risk the exposure to overall rates you don't like.
More...
 
Quote from black diamond:

Here's another way to look at it. Assume you are taking a position in a security affected by mulitple risks. You want exposure to some component of the risk - either you think you make money over the long term from exposure to this risk or it is necessary for a bet you want to make. You don't want exposure to the other risks. Hedging lets you decrease exposure to the risks you don't want.

For example, you buy a particular corporate bond because you think credit spreads are too wide and will come in. But you are exposed to the overall level of interest rates, which you don't like. Credit spreads could come in like you think, but you might still lose money if interest rates rise. So you short some treasury futures as a hedge. Then you have the credit exposure required for the bet you want to make, but you reduce the risk the exposure to overall rates you don't like.
More...

This type of hedging is a way to decreasing volatility and a psycological trick. Think about what this essentially does, your putting a trade leg on with no idea if it will be profitable, thats what a this type of hedge is in effect, blind trading. It doesnt mean its a bad idea, it might very well be, but the arguments for it should be a decrease in volatility and making psycologically easier to hold a portfolio

A more advanced type of hedge which is not really a hedge would be to be short a number of stocks for the long-run and then go long ES in a specific ratio when the market gets oversold(then take ES profits when the condition is cleared), this would increase your profitability(assuming you are right), decrease volatility and making it easier to hold the shorts.
I dont think this should be considered a hedge, its more like 'double trading', you keep looking for opportunities that you think will make money that are inversely correlated. That you get you make money and sleep well, a free lunch
 
Risk transfer is the reason for the season with futures markets. There is no such thing as "AVOIDING" risk in price changes. Price changes are normal as conditions change regardless of the reason why. With proper due dilligence you can protect yourself against adverse price movements but thats about all.

To "HEDGE" a losing position is going to accomplish nothing except raise your commission costs and stress level trying to out manuver a sure loss

A speculator has a job to do and that job is to accept the risk someone else is laying off to the mkts.

When i pull the trigger on the days first trade i have accepted the risk someone else is laying off to me and every other spec. The other guy is offering me a chance to turn his/her adverse price change to my advantage.

Speculators can only lose by defeating themselves when they take on more risk than they can handle.
 
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