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

What is Long Hedge?

A long hedge is a risk management strategy where you buy futures contracts or call options to lock in the price of an asset you plan to purchase later, protecting against rising prices. This approach is common for businesses that want price certainty on future costs.

Unlike a short hedge, which protects against price declines for assets you already own, a long hedge safeguards against price increases on anticipated purchases.

Key Characteristics

Long hedges have distinct features that suit buyers looking to stabilize expenses:

• Position: You take a long position by purchasing futures contracts or call options to benefit if prices increase.
• Price protection: Locks in current prices, mitigating the risk of adverse price movements in the future.
• Hedge ratio: The effectiveness is measured by the hedge ratio, often close to 1 for full coverage.
• Costs involved: Includes margin requirements, commissions, and potential basis risk due to price differences between futures and spot markets.
• Use of call options: Buying call options as an alternative allows upside benefit if prices decline, limiting losses to the option premium.

How It Works

To implement a long hedge, you first identify the exposure by anticipating a future purchase of commodities, stocks, or raw materials that may experience price increases. You then enter a long position by buying futures contracts at the current price, effectively locking in that rate.

You hold this position until the purchase date, at which point you offset the hedge by selling the futures contracts. Gains from the futures can offset the higher spot prices if the market rises, while losses are balanced by lower spot prices if the market falls. This strategy is especially useful for budgeting and cost control.

Examples and Use Cases

Long hedges are widely used across industries to manage price volatility:

• Energy sector: Companies like Chevron and ExxonMobil may use long hedges to secure fuel or crude oil prices in volatile markets.
• Airlines: While airlines often hedge fuel consumption, long hedges help lock in costs for future fuel purchases.
• Commodity processors: A bakery might hedge wheat purchases by buying futures, ensuring stable costs despite fluctuating commodity prices.
• Investment portfolios: Investors might use long hedges or consult guides like best energy stocks to manage exposure to price changes in commodities.

Important Considerations

While a long hedge provides price certainty, it is not without limitations. Basis risk—the difference between futures and spot prices—can reduce hedge effectiveness, and maintaining futures positions involves margin requirements and transaction costs like haircuts.

Additionally, consider the T-account effects on your financial statements and be aware of the market range within which your hedge operates effectively. Assessing these factors ensures your long hedge aligns with your financial goals and risk tolerance.