What is a long hedge’
Long hedge refers to a futures position, which is introduced for the purpose of price stability for the purchase. Long hedges are often used by producers and processors to remove price volatility from the purchase of necessary materials. These dependent input companies know they will need materials several times a year, so they enter futures positions to stabilize the purchase prices during the year. For this reason, a long hedge may also be referred to as the input hedge, hedge buyers, buy hedge, hedge buyers or purchasing hedging.
Breaking long hedge’
Long hedging is a strategy for the intelligent management of costs for a company that knows what it takes to buy the product in the future and wants to lock in the purchase price. The hedge is quite simple, with the buyer of a product just entering a long position on the futures. A long position means that the buyer of the goods is betting that the price of goods will rise in the future. If the item is expensive, the profit from the futures position helps to offset the higher cost of goods.
An example of a long hedge
A simplified example of a long hedge, to assume that it is January and manufacturer of aluminium needs up to 25,000 lbs of copper production of aluminum and to execute the contract in may. The current spot price is $2.50 per pound and may futures price is $2.40 per pound. In January, the aluminum producer will take a long position in 1 futures contract on copper.
This futures contract can be calculated to cover part or all of the expected order. Choice of position, sets the hedge ratio. For example, if the buyer hedges against the floor by the size of the order, the hedge ratio is 50%. If possible, spot copper prices above $2.40 per pound, then the manufacturer benefited from long positions. This is because the total profit from the futures contract to compensate for the increase in the purchase cost of copper in may. If in may the spot price of copper is below $2.40 per pound, the producer takes a small loss on the futures position, while maintaining overall due to the lower purchase price than expected.
Long hedges and short hedges
Basis risk makes it very difficult to compensate all the risks pricing, but a high hedge ratio on the long hedge will remove a lot. In front of a long hedge short hedge protects the seller of a commodity or asset, locking in the sale price. Hedges, long and short, can be seen as a form of insurance. There is a cost to create them, but they can save a company a large amount in an unfavorable situation.