Overview
A “Hedge” is derivative position taken to offset a risk in the physical position today or in the future. By contrast, a speculative position is taken with no offsetting physical position. A hedge may lose value or gain value but should complement the change in value of the physical position.

For a trucking company that needs to buy fuel for the coming quarter, it may want to cap the price paid for its budget period. A hedge would be to buy or “long” an average price call option in heating oil, a close match with diesel fuel. In the event that prices go higher, it will be “hedged” with a financial contract which will pay cash to the hedger each month and offset the higher prices of fuel at the pump.

In energy, a speculative derivative trade is a position taken without the specific goal of offsetting the risk of cash market prices changing in the future.

Risk is mitigated when using derivatives as insurance against unknown future prices. When buying options, risk is decreased as some price will be known for a given period of time. When selling options, risk is increased as the loss from the derivative can potentially be unlimited.

Options are often the best strategy when hedging as they have no unforeseen risk when they are purchased, similar to buying insurance on an asset such as a home or machine. The cost of options is quantifiable when they are purchased as insurance.

Selling options or entering swaps or futures positions creates the potential for large or unlimited loss. Please contact HCEnergy if you have any questions.