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Long Hedge What It Is How It Works Example

Long Hedge What It Is How It Works Example

Long Hedge: What It Is, How It Works, Example

David has extensive experience in financial and legal research and publishing. Since 2020, as a Dotdash fact checker, he has validated over 1,100 articles on various financial and investment topics.

What Is a Long Hedge?

A long hedge is a futures position entered for price stability on a purchase. Manufacturers and processors often use long hedges to eliminate price volatility when buying required inputs. These input-dependent companies know they will need materials multiple times a year, so they enter futures positions to stabilize purchase prices throughout the year.

For this reason, a long hedge may also be called an input hedge, buyer’s hedge, buy hedge, purchaser’s hedge, or purchasing hedge.

Understanding Long Hedges

A long hedge is a smart cost control strategy for a company that needs to purchase a commodity in the future and wants to lock in the purchase price. The hedge itself is simple, with the purchaser entering a long futures position. A long position means the buyer is betting that the commodity’s price will rise in the future. If the price of the commodity increases, the profit from the futures position helps offset the higher cost of the commodity.

Example of a Long Hedge

In a simplified example, assume it is January, and an aluminum manufacturer needs 25,000 pounds of copper to produce aluminum and fulfill a contract in May. The current spot price is $2.50 per pound, but the May futures price is $2.40 per pound. In January, the aluminum manufacturer would take a long position in a May futures contract on copper.

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This futures contract can be sized to cover part or all of the expected order, setting the hedge ratio. For example, if the purchaser hedges half the purchase order size, then the hedge ratio is 50%. If the May spot price of copper exceeds $2.40 per pound, the manufacturer benefits from the long position. The profit from the futures contract offsets the higher purchasing cost paid for copper in May.

If the May spot price of copper is below $2.40 per pound, the manufacturer takes a small loss on the futures position but still saves overall due to a lower-than-anticipated purchasing price.

Long Hedges vs. Short Hedges

Basis risk makes it difficult to offset all pricing risk, but a high hedge ratio on a long hedge reduces much of it. The opposite of a long hedge is a short hedge, which protects the seller of a commodity or asset by locking in the sale price.

Both long and short hedges can be considered a form of insurance. While there is a cost to setting them up, they can save a company a significant amount in adverse situations.

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