A useful practice that every investor should be aware of - hedging is a clever way to protect one's portfolio —and protection is often just as important as portfolio appreciation. It is the act of protecting your underlying investment in case of a massive fluctuation in value in one direction by betting on the same underlying in the derivatives market in the other direction of the movement. Note that hedging is not a money-making strategy, as investment risk can never be eliminated, though its impact can be mitigated or passed on. Hedges are meant to remove only a portion of the exposure risk and no hedge can protect you from losses completely.
In today's world of finance, trades, and investments, nearly anything can be hedged - equities, interest rates, commodities (like crude oil, silver, natural gas, etc), currency exchange rates, etc. In this article, we will be specifically covering hedging in the commodities section.
Wealthy investors or hedge funds do not generally tend to have long-term holdings of commodities ( exceptions like gold, silver, etc. apart), as they do not appreciate multi-fold in wealth creation the way stocks of good companies do. Therefore, while hedging is done in stocks and stock indices to offset short-term losses for long-term investments, hedging in commodities is primarily done by businesses that require these commodities to protect their expenditures in case of rising costs.
A classic example of a company hedging its expenditure on a commodity is that of a tequila corporation. Let's say a tequila company named 'Company T' is concerned about the volatility in the price of agave - i.e. the plant that is used in tequila production, as T's profits and finances would be in tatters if the price of agave skyrockets.
To protect their finances against this risk of rising agave prices, T enters into an agave futures contract to buy this agave at a specific strike price at the contract expiry date. With this hedge now in place, they will not have to worry about rising prices destroying their profits too much. If agave prices do increase above this strike price, this hedge will have benefitted T as they would be paying a lower price.
However, the problem with such futures contracts is that if the price goes down, T is still obligated to pay the price in the contract, unlike an options contract where the buyer has the right but not the obligation to fulfill the contract. In this scenario, it would've been better in hindsight to not have hedged against this risk, but that's what makes hedging risky and a double-edged sword, especially if the instrument being used is futures.
So why can't companies trade on commodity options, where there will be no obligation to settle?
To provide an answer specific to Indian markets, commodity options took a lot of time and delay to be introduced on the Multi Commodity EXchange of India (MCX) and is a relatively new instrument compared to equity options, stock index options, or even commodity futures. As a result of this, there is a massive lack of liquidity in commodity options compared to the futures contracts of the same commodity, with these options receiving a go signal from SEBI only by late 2017.
Another important catch in this: unlike Nifty options where the underlying is the spot price of the Nifty index, or crude oil futures (an example of a commodity) where the underlying is the spot price of crude oil in the New York Mercantile Exchange (NYMEX), the underlying of crude oil options is actually crude oil futures, not the spot price of crude oil itself.
It is important to understand this, as crude oil itself does not have a 'spot price' in India. But crude oil futures is a vibrant market in India, which is the reason why crude oil options contracts have used crude oil futures as the underlying itself. This can cause massive fluctuations in the value of the contract, with options contracts being a derivative of a derivative.
To summarize, commodity options lacking liquidity so far in India and prices of options depending on the underlying commodity futures has resulted in commodity options not having quite taken off in India yet. So businesses requiring a certain commodity, like agave for tequila companies or fuel for airline companies, hedge their risk for this expenditure by using futures contracts of the same products to ensure that fluctuations in prices do not cause a major dent in their overall profits.