Hedging Terminology
Hedging actively will require an understanding of terms that commonly used by traders and brokers. These terms are important to understanding the concepts necessary to build a hedging strategy, to plan and execute trades, and to understand your hedge positions while managing a hedge program. Some of these terms are similar to terms used in stock trading. Many times they will have similar meaning, but in some cases — ‘margin’ for instance — their meaning will be significantly different. POWERHOUSE has helped many client get up to full speed with hedging and hedging language over the years.
Below you will find a short list of key terms to help you get familiar with some of the most commonly used hedging terms. As always, if you have any questions do not hesitate to contact us.
Basis:
Basis is the difference between a local market price for a commodity and the price for that same commodity in the futures market. If heating oil in Springfield is selling for $1.50, and the futures price for heating oil at New York Harbor is 1.54 there is a $0.04 basis difference between Springfield and the NYMEX.
Bid/Ask:
Financial market prices are displayed as two numbers. The “bid” price is the highest price someone in the market is willing to pay to buy the instrument in question. The “ask” price is the lowest price at which someone is willing to sell the instrument. Eventually, someone will either cross the spread and take the bid (in the case of a seller) or ask (in the case of a buyer) price to execute a trade.
Futures:
A standardized contract, traded on a regulated exchange, to buy or sell a specified quality and quantity of a commodity at a specified price and time in the future.
Long:
If you own an asset, you are considered to be “Long” in that asset. Having fuel in inventory means you are long physical fuel.
- A long hedge is employed to protect firms from prices rising in the cash market
- A long hedger buys futures contracts
Short:
If you have sold an asset you don’t yet own, you are considered “Short” in that asset. If you have sold fuel for delivery in the future (and you do not yet have that fuel in inventory) you are short physical fuel. Similarly, you can sell a futures contract today (establishing a “short” futures position), and sell that contract in the future.
- A short hedge is employed to protect firms from prices falling in the cash market.
- A short hedger sells futures contracts
Margin:
Collateral deposited with an exchange for each contract held (long or short) as a performance bond against taking or making delivery of the contract. The collateral requirement is eliminated when the contract position is liquidated.
NYMEX:
New York Mercantile Exchange (NYMEX) is the world’s largest physical commodity futures exchange.
Options:
A standardized contract that allows a buy (call) or sell (put) an underlying futures contract at a specific price on a specified date.