Oil Hedging, It Is Not Only For Energy "Hedge Funds"

Hedging strategies can often be complex, which usually scares a lot of investors away from utilizing the strategy. Most average investors have not even heard of a "hedge" for investing. You may believe hedging is more for active investors, or those who make their living from investing, or those who are trader, or other reasons. In reality, hedging is a great tool when done properly for investors of all types.

So what is a hedge?

A hedge as an investment strategy is when you open separate positions in different markets in a way so that the two positions offset the risk of each other. Usually, they involve the use of different financial instruments such as derivatives and futures.


How can you employ a hedging strategy to the oil markets?

There are a variety of ways, here are some which we have tried to explain in simple terms:

Hedging Strategy #1- If you believe oil prices rise:

• Buy a put option on oil, do this through an account which permits and has options trading such as CBOE, OptionsXpress, or NYMEX
  

• Second, you will want to buy a little smaller oil future contract. 

Now, if oil rises in value you will money on your oil future and just let your oil option contract expire, losing no money on the options contract (except for the small fee). If oil drops in value you will lose money on your oil future, but then you will close your future and exercise your option and make the amount you lost on the future back, plus a little more (since you opened a slightly larger option contract)

Hedging Strategy #2 - If you believe oil will decrease in value:

• Buy a call option on oil,

• Sell short an oil future,

Now if oil drops you will make money on your oil future, and let your option expire. If oil rises in value you will lose money on your future, but then close your future and exercise your option.

Hedging Strategy #3 - If you believe oil prices will rise:

• Buy an oil swap (you pay a fixed rate, while you receive the floating rate)

• Buy an oil put option

Here if oil rises in value you will make money on your swap, but not lose any money on the put because you will not exercise it, but instead let the put expire. If oil prices drop in value you will lose money on the swap, but exercise the put option and make money on the option.

Hedging Strategy #4 - If you believe oil will decrease in value:

• Sell short an oil future,
  

• Buy a swaption at the same price

Here if oil decrease in value you will make money on your short oil future, but not lose any money on the swaption because you will not exercise it, but instead let the swaption expire. If oil prices rise you will lose money on the oil future, but exercise your swaption so you will then make money on your swaption.
 
These are the basic outlines of several hedging strategies you can implement to decrease risk and become exposed to the oil market. Any of these strategies when implemented properly will work excellent, but it is important you understand what you are doing fully.

If you would like to open a hedged position on oil, or would like to know more about other oil hedging strategies then please give us a call at 262-939-8885. Thank you for reading and have a great weekend!