Hedging is primarily, as this post will focus on, the option to take the risk out of the spot movement based on your business or your exposure to the market. If you're a private stacker, you may still want to hedge, but I would only consider hedging as an individual if you tick most of the following: 1. You are risking funds in the metals that you cannot afford to lose or if you are leveraged. 2. You are not buying the physical for price exposure, but rather insurance, and "locking in" a price is fine for you - especially if there has been a massive run up that you are convinced will be short-lived for the foreseeable future. 3. The price has moved to a point you would consider taking profits at but don't want to or cant offload the physical right away (or at all) Hedging isn't something most physical stackers should need to consider. They are in the metals because they are bullish - end of story. Tho - sometimes its prudent (not necessary) to consider hedging if you tick any of the above. Hedging is something one could consider if you're a business that can be adversely affected based on what spot movement does. How do you eliminate the risk of spot movement? There are many ways you can try. Options are a terrible way to hedge because it costs you money that you may never get back. Its like insurance. If you don't need to claim on it you've lost the money you paid for it. This is not true hedging, its merely insurance. True hedging is eliminating the spot price movement risk altogether (up or down) where as options are only one way. Unless you buy calls and puts - in which case you're really throwing unnecessary money down the toilet and still not completely hedged. In the example, we're going to use jenny the jeweller as our hedging example. Jenny sells silver jewellery. She runs a tight ship. After her time, business expenses, staff expenses etc, her profit margin is 20%. That is, for every ounce of silver she buys, she can expect to make 20%. Now she has a markup of about 300% on her silver products, that is - the silver content of her product is valued at 1 third less than the selling price, but because she has many other expenses to get the silver jewellery to market, while 300% sounds like a lot, she is only making 20% after everything is paid for. However, because there is time involved from when she buys her silver to when she puts it in the retail stores up for sale, the price of silver can move considerably. Sometimes this works in her favor. Jenny may buy silver at $20 per ounce, and by the time it hits the shelves, its $30 per ounce, she can charge more for the jewellery. However, Jenny can also lose on potential profit if the price of silver drops and she has to ask for a lower price to remain competitive. Infact, because Jenny only runs at a 20% profit, if silver drops 20% this can seriously affect her bottom line. At the end of the day, Jenny is a Jeweller, not a trader. She would love to remove the trading element out of her business... so she starts to hedge her transactions. Now, lets assume Jenny is the USA for simplicity in currency conversions since cross-currency hedging has an added layer of complexity which we can look at in part two of this thread. So Jenny goes to the bullion dealer to pick up 1000oz of silver for her next batch of jewellery and pays, say $30 / oz , $30,000. When she gets home, she sells 1000oz of silver electronically through her broker. Some would say now the hedge is over and Jenny is now fully hedged. Since if silver goes up to $40 by the time she makes her jewellery, then the silver content is worth $10,000 more but her silver hedge is worth $10,000 less - so the net effect is zero - silver is still, as far as Jenny is concerned, at $30/oz because of her hedge. Likewise if silver falls to $20 - her hedge trade is up $10,000 but the silver she bought is worth $10,000 less. So she's hedged right? No - its not that simple and here's why. Jenny's jewellery may be on the shelf for weeks or months, and incremental amounts are sold at any given time. That is, let's say in the first two weeks of selling that batch of jewellery, only 300oz has been sold, jenny is still hedged 1000oz. That means now she is 30% NET SHORT silver and infact over-hedged in her business, she is now hoping (gambling, speculating) that silver will drop in price so her 1000oz hedge will be worth more than her 700oz of remaining silver. If silver goes up in value, she's only improving on 700oz of silver, but her hedge is losing value at 1000oz - she is net short 300oz. So she now has the same problem she started with. How can jenny eliminate the exposure to the market? This is where choosing a suitable broker to accommodate Jenny's needs becomes key. Going direct to the metal exchanges, ie CME or LME, will require Jenny to work in no less than 5000oz contracts, something that Jenny's business just can't deal with. 5000oz is great for mining companies that can sell that amount (infact many multiples) in one go but for jenny, her 1000oz in silver may take her 2-3 months of gradual sales. Can anyone help her? Answer is yes. There are many brokers offering derivatives on the silver price. ABC Brokers allow jenny to trade in 50oz contracts for example. This will suit Jenny fine, she can sell 50oz a week and the underlying risk of being hedged/unhedged any less than that is inconsequential. So Instead of Jenny selling 1x1000oz contract, she sells 20x50oz contracts through a broker that has setup a derivative for this kind of contract. Now, every time Jenny sells 50oz of silver jewellery, she closes 1 of her contracts and she's sorted. Completely hedged, risk free. This also assumes she updates her prices at the end of every trading day. If Jenny just said my prices are $x until they are all sold - she may be ok to open just one 1000oz contract. But this is also of the assumption that silver wont do anything drastic while her jewellery is on the shelves. What if it crashes 30% like it did recently? Jenny would be forced to lower her prices to remain competitive so she'd need the added flexibility at that time of the 20x50oz contracts. Also - Hedging means Jenny CAN BE more competitive than others in the market - if silver does drop 30% - she can lower her prices instantly because she's making it back on her hedge - whereas other jewelers still living in the dark ages are forced to either take the loss or keep prices higher. The next post will show how Jenny can open a store in Australia, and still remain hedged since there are no brokers (at least not that I know) that offer silver derivatives of the AU $ Spot price. This is called cross currency hedging and involves two trades, one for the US denominated silver, and one for the AUD/USD fx currency pair.
+1 P.S. Don't forget, one can't completely eliminate risk, but it is possible to manage it! P.P.S. Also, can Jenny choose to hedge a portion of her stack/consumption...not all of it, that way she may have some beneficial exposure to price changes ?
for sure. but the moment she says she wont hedge at all - her business is at the mercy or windfall of the markets - and she has to assess if thats why she is a jeweler, to make it on the markets or to run her business with diligence. Also - IF you do fall (or think you will fall) into the category of 3. The price has moved to a point you would consider taking profits at but don't want to or cant offload the physical right away (or at all) you should setup a trading account now and know how to do it when the time is right. Some stackers I know have a price point in mind (i.e. sell what I have at $50 or $100 or whatever their number is) well as we know - the markets can remain at these psychological numbers for a short period of time and you might not get the chance to come home from work, get the silver out of the safe and down to the dealer or whatever. It may touch $100 and be $80 again while you're waiting in line at the dealers. If you miss your chance to sell, you may be waiting a while (if ever!) for it to get back over your target price. If you have a plan re your silver and are not just buying and holding till the cows come home - but do have an exit strategy - then a trading account and learning to place hedge trades may prove to be a good investment of your time. So if you think that MAY be you in the future - setup an account now and even demo a few trades on a demo account so you know what you're doing -then setup a live account. You may never use it - but you may also be thankful you did.
KEH? Good write up but it sounds like an Italian version of a chinese soccor match. I prefer the bird in the hand method, I'd rather just have hunks of the real stuff lying around purely because if I have it, then I own it, and if it spot drops I still own it.
Nice posts John, I have a couple of questions one a little personal and you don't need to answer if you don't want to. 1) when you sold your physical stack (which I really don't have an opinion about, it's your business) why would you choose to do this? At the time and even now I still cannot understand why you would not have just opened a short trade on the xagusd and a long on the audusd with your profit point at the $35 you identified. Seems to me that it would be far easier and with tighter spreads to do this than have to physically offload your stack and then repurchase. I am not criticising your decision I am genuinely interested in understanding this if i have missed something. 2)Possibly more of an observation than a question but id just like to point out to people who may not be aware that if you do wish to hedge you will also require additional funds to cover this. If you are 100% metal with no cash it is near on impossible to place a hedge as outlined by John. In the case of Jenny and the price rising $10/oz, with 1000oz to hedge she will need to have an additional $10,000 to cover this trade. She will pick this up on the roundabout when she sells her jewelry for an extra $10/oz. But she will still need to have this additional capital on hand to maintain the position. It would be terrible if she only had margin for a $10 rise also and got 'stopped out' at or margin called at $30/oz, only to have the spot price then fall back to $25/oz before she can sell her jewelry. Her Hedge has cost her $10/oz but she is only recouping $5/oz on the sale. Just in case people had fantasies about going 100% into metal with the idea of short selling at 'the top' and retaining your stack.
I think that this is all quite interesting even though the likelihood of getting involved in hedging is probably slim for most of us. Understanding the bigger picture, especially since some of the dealers and bigger players engage in hedging, is always helpful. Thanks Stella for the info and everyone for the questions that I don't know enough to ask.
What if I was wrong and silver went to $75 or $100? Only in hindsight was the best thing to do would be to bet the house, kids and dogs on a short... but one can only know that after the fact. What if I didnt sell, but shorted my entire stack worth, and silver went to $75. I would have to sell the silver to cover the losses Taking profits is a very different thing to betting the price would go down. As a trader I shorted at the highs, but that was a trade - not taking profits as an investor. Correct. A hedge ties up funds but its not costing you anything... I guess that why people look to options to hedge because its a much smaller 'once off' fee - but with options its funds you might not get back.
Another alternative method is to post collateral (eg standby letter of credit) and just borrow silver. You can then sell when and how much you want without restriction.
You have to also include the 'cost of hedging' - the cost of capital of the cash you use to post initial and maintenance margin. Even if you have a physical position perfectly offset by a futures contract, you will have a slight non-linearity in your P&L due to the fact that: - If the price goes up, you make money on the physical, lose an equal amount of money on the future, and lose the cost of funds for the margin call (eg, either borrow funds, or take it out of an interest bearing account) - If the price goes down, the opposite holds, you lose money on the physical, make money of the future, and have some of your margin funds are returned into an interest bearing account (but you still have to keep the initial margin amount posted) For small amounts, this won't make a difference compared to the price certainty benefit, but if you're a large market participant, then these effects can cost a lot. Also, a problem if margins are raised, cause then you're funding more margin without a corresponding increase in your P&L
