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The long and short of it

Are you long or are you short? When looking to use derivatives such as futures or options, the first thing you need to understand is whether you are naturally long or short the commodity you are looking to hedge.

Long
If you are long, you have ownership of a commodity that you may need to sell at a later date to generate cash flow.
A grain grower is naturally long grain and needs to sell the grain to generate cash flow.

If you are naturally long a commodity, you have a natural market requirement to sell that commodity at some point in time. If you need to sell, you don’t want the market value of your commodity falling before you actually sell it.

To hedge a natural long position, you may be interested to execute a short hedge strategy to offset your market risk. A short hedge is one in which you are looking to sell futures directly or indirectly by using options.

Long Examples Market Risk Short Hedge Examples

 A grower with a crop to sell.

Falling grain prices Sell futures
Buy put options
 A trader that has bought more grain than sold. Falling grain prices

Sell futures
Buy put options

 A bank that has financed a grower's cropping programme.

Falling grain prices

Sell futures
Buy put options

Short
If you are short, you do not have ownership of a commodity that you need and therefore will be looking to buy at a later date. A flour mill is naturally short wheat and needs to buy wheat year round to keep the mill operating. 

If you are naturally short a commodity, you have a natural market requirement to buy that commodity at some point in time. If you need to buy, you don’t want the market value of your commodity requirement to rise before you actually buy it.

To hedge a natural short position, you may be interested to execute a long hedge strategy to offset your market risk. A long hedge is one in which you are looking to buy futures directly or indirectly by using options.

Short Examples Market Risk Long Hedge Examples
 A feedlot with cattle to feed needs to buy the feed grain. Rising grain prices

Buy futures
Buy call options

 A trader that has sold more grain than bought. Rising grain prices Buy futures
Buy call options
 A grower who has forward sold more than can be produced. Rising grain prices

Buy futures
Buy call options

A flour mill needs to buy wheat to mill.

Rising grain prices

Buy futures
Buy call options

Market news

Source: Source DowJones View all Market news