Part 3

This operation is particularly useful to jobbers with whom conditions are such that they desire to be assured that their cost will be at about the market price at the time they dispose of their sugar, regardless of whether the market be higher or lower.

Although there are times when any jobber, no matter where located, will find this a useful transaction, it is obvious that many buyers will not wish to use the market in this way unless they feel it will decline. But it is particularly of advantage to a jobber located in markets necessitating a delay of from one day to several weeks in transit.

For instance, on a certain day in April, two jobbers bought their usual quantity of sugar. One was located in Syracuse, the other in New York. Two days following the purchase, the market broke half a cent per pound. In view of the fact that his sugars were still in transit when the market declined, the Syracuse buyer was obliged to sustain this entire loss, in order to meet competition. On the other hand, because he received and distributed the sugar before the market broke, the New York jobber was able not only to avoid a loss, but make his regular profit.

CHART 1

---------------------------------------------------------------------------- HEDGING to protect a normal jobbing profit by eliminating the probability of a speculative loss or gain ------------+-----------------------------------------+-----------+--------- Initial | | Transactions| Subsequent Transactions | Result ------------+-----------+---------------+-----+-------+-----------+--------- |Liquidating| Condition |Price| Result| Figure | In each | the hedge | of market | you | of | your | case |(covering) | when you |would| hedge | sugar | the | | "cover" | pay | cost | cost | same | | your hedge | in | this | this | | | |cover| way | way | | | |-ing | | | ------------+-----------+---------------+-----+-------+-----------+--------- You buy | When you | | |Profit |Actual cost| actual sugar| sell your |It has declined| | |less profit| at 6.00 | sugar (or |to 4.00 |4.00 |2.00 |6-2=4 | | when it is| | | | | | delivered)| | | | | | you buy | | | | |You get | the same | | | | |your | amount of | | | | |sugar | futures at| | | | |at the | the market| | | | |market | price, | | | | |price | whether | | | | |at the | higher or | | | | |time | lower. | | | | |when you | | | | | |sell it | | | | | |(or when At the same | | | | |Actual cost|your time you | |It has advanced| |Loss |plus loss |delivery hedge by | |to 8.00 |8.00 |2.00 |6+2=8 |is made.) selling the | | | | | | same amount | | | |No | | of futures | |It stands at | |profit,|Actual | at 6.00 | |6.00 |6.00 |no loss|cost | ------------+-----------+---------------+-----+-------+-----------+---------

Naturally the greater the amount of sugar any one concern may have in transit the greater the need for protection. We call this kind of transaction particularly to the attention of buyers having branch houses who find themselves obliged to make relatively large purchases to supply their trade in the face of a market in which they have no confidence.

These disadvantages at which out-of-town buyers are sometimes placed might be overcome by using the Exchange. On the other hand, when refiners are badly behind on deliveries, even buyers located at the source of supply will find themselves facing a similar problem the solution of which may be found in a use of the Exchange.

It is therefore evident that the selling of futures may be a transaction the sole purpose of which is to eliminate speculation from a jobber's business.

Regardless of how careful a buyer may be, there is an element of speculation in each purchase of actual sugar.

If the price goes up, there is a speculative gain--the sugar is worth more. But if the price goes down, the buyer sustains a speculative loss.

The measure of protection afforded by the Exchange will appeal to those jobbers who wish to reduce the speculative element in their business.

In the example immediately following, as in all others, we have not taken into consideration the difference between the Exchange quotations and the Seaboard Refiners' quotations, which is explained on page 38. This would simply inject an unnecessary complication, and would be of no particular advantage for purposes of illustration.

Suppose you should buy through your broker from a refiner, for prompt shipment, an amount of actual sugar at 6.00, which you plan to sell within a short time after its receipt. Instead of worrying about subsequent sugar price fluctuations, you simultaneously hedge this purchase by selling futures in the same amount on the Exchange. The price at which you buy actual sugar and the price at which you sell futures should be relatively the same, since Exchange prices generally reflect refiners' prices.

You should be able to figure the cost of your sugar at about the market price at the time it is received or sold. (See Chart 1.)

If the price of sugar should go down to 4.00 at about the time when you sell it, your actual sugar, for which you contracted to pay 6.00, would be worth only 4.00; but you would then buy to cover your futures sale, making 2.00 on this transaction, which, subtracted from the price you paid (6.00), brings the cost down to the market price of 4.00. In other words, you have accomplished your purpose of being able to figure your sugar cost at the market price at the time when you received it (or at the time you sell it). That is, although every pound of actual sugar was sold at a loss, this loss was balanced by the profit from your hedge.

If, on the other hand, the market should advance to 8.00 after your original purchase and hedge at 6.00, the value of your actual sugar would be increased by 2.00. You would then buy futures at 8.00 to cover your short sale at 6.00, netting a loss thereby of 2.00. This loss would be added to your original cost of 6.00, making your actual sugar cost 8.00, which is the market price at the time. Had you omitted the hedge, your sugar would have cost you only 6.00, but, in this example we are assuming that you would sell only when you were willing to figure your sugar cost at the market price. This you have accomplished by foregoing the speculative profit you might have made in favor of your normal jobbing profit.

If the market should remain relatively stable you would buy to cover your hedge at approximately the same price as you sold for, your gain or loss being practically nothing. In other words, you would obtain sugar at the market price, which is the purpose in this kind of a hedge.

HEDGING to protect a gain on a favorable purchase of actual sugar.

All sugar buyers have had the experience of buying actual sugar, only to see it advance or decline before they have disposed of it. How to protect the gain, or minimize the loss, is described in the two hedging positions which we now discuss.

Suppose you have bought sugar, have not hedged against it, and have seen it advance. Finally you have said, "I think sugar is about as high as it is going. I am going to sell against that to protect that profit."

On the other hand, the reverse might be the case. You might find the market going down, and say, "The market is going lower. I want to hedge against that, and limit my loss to a definite amount."

CHART 2

---------------------------------------------------------------------------- HEDGING to protect a gain on a favorable purchase of actual sugar --------------+-----------------------------------------+----------+-------- Initial | | Transactions | Subsequent Transactions | Result --------------+--------+----------+---------+-----------+----------+-------- | Hedge |Condition |Price you| Result of | Figure | In | |of market | pay for | hedge and | actual | each | | when you | futures | covering | sugar | case | | "cover" | to cover| operation | cost | the | |your hedge| hedge | | this way | same --------------+--------+----------+---------+-----------+----------+--------- You buy actual| | | | |Price paid| sugar at 6.00,| | | | |for actual| but before you| |It has | | |sugar less|Your have received | |declined | | |hedging |sugar it (or before | |to | |A profit |profit |cost you sell it) | |6.00 | 6.00 |of 2.00 |6-2=4.00 |is the price | | | | | |2.00 advances to | | | | | |under 8.00 | | | | |Price paid|the | | | | |for actual|market You now have |You sell|It has | | |sugar plus| your sugar at |futures |advanced | | |hedging | 2.00 under the|at |to | |A loss |loss | market |8.00 |10.00 | 10.00 |of 2.00 |6+2=8.00 | | | | | | | You feel that | |It stands | |No profit, | | the market may| |at 8.00 | 8.00 |no loss | 6.00 | recede and | | | | | | eliminate | | | | | | this gain, | | | | | | so-- | | | | | | --------------+--------+----------+---------+-----------+----------+--------

In both of these cases, the operation is relative. If a man has a profit, let us say 2¢ a pound, and he hedges, he maintains his profit of 2¢ a pound as compared with the market at the time of delivery, or at the time when he expects to sell this sugar, regardless of whether the market is higher or lower.

In the same way, conversely, if he has a loss on his sugar of 2¢ a pound, by hedging he can limit that loss to 2¢ a pound, even though the market goes still lower. In other words, his sugar cost at the time of delivery, or at the time when he expects to sell the sugar, will be about 2¢ above the market price, whether the market is higher or lower.

We shall assume that you have bought from a refiner through your broker a supply of actual sugar at 6.00. While your sugar is in transit or before it has been shipped by refiners, the market advances to 8.00, at which point it apparently is steady. You now have a theoretical gain of 2.00--that is, if you were to sell your sugar at once, you would have an actual profit of 2.00; but you do not sell because your sugar is in transit or you need it for your trade. However, you do want to preserve and protect this favorable position of having your sugar 2.00 below the market at the time you want to sell it. So you sell the same quantity of futures on the Exchange at 8.00.

Three things may occur--the market may decline, or it may continue to advance, or it may remain steady. You have accomplished your purpose in any case (see Chart 2).

By the time you sell your sugar (or at the time of its delivery) it becomes necessary for you to cover your hedge and if the market has declined from 8.00 (at which point you hedged) and stands at 6.00 again, your hedging operations considered alone would net you an actual profit of 2.00. Your original sugar cost was 6.00. Your profit on your hedge was 2.00, so that you would figure your actual sugar cost at 4.00. You would have accomplished your purpose of getting your sugar 2.00 under the market at the time of selling it (or at the time of its delivery). That is, your delay in selling your sugar has cost you practically nothing, even though the market has declined.