Hedging Silver

Hedging is done to mitigate the risks associated with the change in price of an asset. Most of the commercial establishments that deal in physical markets such as manufacturers, traders, wholesalers, or retailers use derivative markets to hedge their business risks.

Hedging involves in establishing a position in the futures market that is equal and opposite to the position held in the physical market segment.

As the price movement of futures contract mirrors the price movement of the underlying, the opposite position taken by the hedger results in locking-in of the price of the asset. The loss in one market is compensated by the gain in the other market.

Hedging activity can be classified as:

Short Hedge: involves selling futures contract to cover the risks of a long position in the physical commodity.

Long Hedge: involves buying a futures contract to cover a short position in the physical commodity.

The following two examples will make hedging clear:

Short Hedge
(Long Physical / Short Future):
John Doe, a gold & jewelry shop owner holds 3000 kgs of silver that he bought at $9.75 per troy ounce (TOZ.)

He wants to protect himself from the risk of adverse price movement. As he is long in physical silver, he should take an equivalent short (sell) position in Silver Futures. For a silver futures contract, the underlying quantity of silver is 1000 TOZ or 30 kgs.

John Doe accordingly, sells 100 silver futures contract at a price of $9.85/TOZ. The contract is to expire after 2 months. After a month the price of spot silver fell to $9.35/TOZ.

John Doe sold off his stock at that price. He simultaneously removed the hedge i.e. bought back the 100 silver futures contracts @ $9.45/TOZ.

His net profit/loss position will be:
• Loss in Physical stock:
$0.40/ TOZ. (9.75 – 9.35)
• Profit in Futures position:
$0.40/ TOZ. (9.85 – 9.45)

If the hedge had not been undertaken John Doe would have lost $ 0.40/ TOZ which would have resulted in a whooping total loss of $40,000/- (0.40 * 100 * 1000).

Long Hedge
(Short Physical / Long Future):
On 15th April, John Henry a silver merchant took an order to supply 300 kgs. of silver @ $10.15/- TOZ in June 2006.

The spot price at the time of taking the order is $10.05/- TOZ and July 2006 silver futures contracts are selling at $10.25/ TOZ.

John Henry wants to take a hedge. He buys 10 silver futures contracts @ $10.25/ TOZ. on 15th April. At the time of delivery of the order in June, the Silver prices rise to $10.65/ TOZ. In order to fulfill his commitment John Henry buys silver at that price and delivers it to the buyer.

He simultaneously removes the hedge by selling the 10 silver futures contract at $10.80/ TOZ.

His net profit/loss position will be:
• Loss on physical silver:
10.65-10.05 = $0.60/- TOZ.
• Total loss:
$6000/- (0.60 * 10 * 1000)
• Profit in Futures:
10.80-10.25 = $0.55/- TOZ.
• Total Profit:
$5500/- (0.55 * 10 * 1000)
• Net loss incurred:
$500/- ($6000 – $5500)

In this example, even though John Henry hedged his position, it did not eliminate his losses fully. But it helped him mitigate losses to the extent of ($5500). If the hedge had not been taken, he would have lost ($6000) instead of a trivial ($500).