How to Hedge in Commodity Trading? What Hedging Strategies Can Be Adopted?

TradingKey - Since the threat of tariffs from Trump, commodity prices have repeatedly reached new highs. On March 31, 2025, the price of gold exceeded its previous all-time high of $3,100. As of the week ending March 19, 2024, asset management institutions like hedge funds increased their long positions in six types of oil-linked futures options contracts equivalent to 140 million barrels of oil. This large-scale increase in long positions for crude oil futures options set a record for the largest single-week purchase since December 2010.

In this uncertain international environment, options and futures emerge as crucial risk management tools in commodity trading.

So how can one skillfully employ advanced trading strategies such as hedging, managing risks with futures options, and speculating based on market trends in commodity trading? This article will provide answers to these questions one by one.

Hedging refers to simultaneously executing two transactions that are correlated in market movements, opposite in direction, equivalent in quantity, and offsetting in profits and losses, thereby reducing investment risks.

In commodity investing, prices are subject to frequent and significant fluctuations due to complex factors such as the global economic climate and political dynamics. As a result, hedging strategies are critical.

1. Futures Hedging

For commodity investors, futures contract hedging is one of the most frequently used methods.

By buying or selling futures contracts corresponding to the physical commodity, you can lock in future prices in advance, thereby mitigating the risk of price volatility.

Example

Imagine you own an oil company and expect a possible drop in crude oil prices. To reduce risk, you sell a futures contract for crude oil delivery six months later. At the time, the spot price is $68 per barrel, while the futures price is $71.

Six months later, the spot price drops to $62 per barrel, and the futures price falls to $65. Although revenue from the spot market decreases, the profit from the futures market compensates for the loss.

This illustrates the fundamental concept of futures hedging—leveraging profits in one market to counterbalance losses in another.

Common Applications:

• Hedging (Risk Management)

For producers, processors, or traders, hedging is a vital risk management tool.

If a company is concerned about rising raw material prices, it can lock in procurement costs by purchasing futures contracts in advance.

On the other hand, if there are worries about a decline in prices, the company may opt to sell futures contracts to protect its sales revenue.

Another Example

A soybean producer worried about future price drops might purchase a put option.

If prices indeed fall, the producer can exercise the option to sell soybeans at a predetermined higher price, thereby minimizing losses.

• Basis Trading

Basis refers to the difference between the spot price and the futures price.

Traders can exploit this differential for hedging or arbitrage when the basis changes.

For instance, if the basis strengthens (i.e., the spot price rises more than the futures price or falls less), a short hedge (selling futures) becomes more effective, as gains in the futures position offset losses in the spot market.

• Calendar Spread Arbitrage

For the same commodity, prices often vary across different delivery months. When such spreads deviate from normal ranges, traders can profit through calendar spread arbitrage.

If the near-month contract is overpriced relative to the far-month contract, you might sell the near-month contract and buy the far-month one. Once the spread normalizes, you close both positions to capture profits.

This strategy reduces risks from price volatility in a single contract while generating relatively stable returns.

(Source: Freepik)

2. Options Hedging

Options hedging offers greater flexibility, allowing you to select strategies based on your risk tolerance.

Buying Protective Put Options

If you hold physical commodities or long futures positions but worry about potential price declines, you can buy put options for protection.

If prices fall, profits from the put option offset losses in your physical or futures positions.

If prices rise, you only incur the option premium cost while still benefiting from upward price movements.

Selling Covered Call Options

If you hold physical commodities and expect limited short-term price appreciation, you can sell call options to earn premium income.

If prices remain below the strike price, the options expire unexercised, allowing you to retain the premium.

• One-Sided Hedging

What is One-Sided Hedging?

The core of one-sided hedging is limiting maximum losses by purchasing put options while preserving gains from rising physical commodity prices.

• Collar Strategy

The collar strategy is a more intricate hedging approach that encompasses purchasing a put option while concurrently selling a call option to achieve a zero-cost hedge.

Example:

Imagine you possess a quantity of physical crude oil priced at $70 per barrel. Concerned about potential price declines, you purchase a put option with a $65 strike price and sell a call option with a $75 strike price.

If oil prices drop to $60 per barrel, you exercise the put option to sell at $65, capping your losses.

If prices rise to $80 per barrel, the buyer of your call option will require you to sell at $75, meaning you forfeit gains above $75.

Therefore, the core idea behind the collar strategy is to give up some potential gains in return for protection against losses, leading to a zero-cost hedge.

• Customized Over-the-Counter (OTC) Options

For businesses, standardized options contracts may not fully address complex hedging needs.

OTC options are non-standardized contracts negotiated between businesses and financial institutions, tailored to a company’s specific risk exposure.

(Source: Freepik)

Hedge Ratio Assessment

The hedge ratio is a critical metric measuring the proportion between hedged positions and physical positions. Theoretically, a perfect 1:1 hedge ratio is ideal.

However, in practice, achieving a precisely accurate hedge ratio is challenging due to market complexity and volatility.

For example, when hedging with futures contracts, if an investor holds 100 tons of physical commodities while the futures contract covers only 95 tons, the hedge ratio becomes 0.95, deviating from the ideal. This discrepancy may impact hedging effectiveness.

Hedge Effectiveness Analysis

The core objective of hedging is to reduce price volatility risk. How can you verify whether this goal is achieved?

This can be evaluated by comparing price fluctuations before and after hedging.

Specifically, statistical methods can be applied to calculate the standard deviation of the portfolio’s returns pre- and post-hedging.

A smaller standard deviation indicates reduced price volatility and more significant hedging effectiveness.

Example:

Suppose a portfolio’s return standard deviation is 15% before hedging but drops to 8% after implementing the hedging strategy. This clearly demonstrates that the hedge effectively reduced price volatility risk and enhanced portfolio stability.

Cost-Benefit Consideration

When evaluating hedging strategies, effectiveness alone is insufficient—you must also assess costs.

If the cost savings from reduced risk exceed the expenses of hedging operations, the hedge can be deemed effective.

Example:

A company incurs 100,000 yuan in transaction fees and margin capital costs for futures hedging. However, this hedge successfully avoids a 500,000 yuan cost increase caused by a sharp rise in raw material prices.

The hedge’s benefits far outweigh its costs, justifying its implementation.

Risk Exposure Assessment

Does Risk Remain After Hedging? How to Quantify Residual Risk Exposure?

Risk exposure refers to the portion of risk unprotected by hedging.

In foreign exchange hedging, for instance, a company must carefully assess residual currency risk exposure. If this exposure is too large, significant volatility risk remains, necessitating further adjustments to the hedging strategy to mitigate risk.

Trend-Following Strategy

Trend-following is one of the most fundamental speculative approaches. Its core principle is simple: ride the trend.

Buy during an uptrend to capitalize on rising prices.

Sell during a downtrend to avoid losses from falling prices.

This may sound straightforward, but a critical question arises: How do you identify an emerging market trend?

This is where technical analysis tools come into play!

You can use Moving Averages (MA) to determine trend direction.

When the short-term MA crosses above the long-term MA, it forms a "golden cross," signaling potential upward momentum.

The Relative Strength Index (RSI) helps identify overbought or oversold conditions.

An RSI above 70 indicates an overbought market, suggesting a possible price correction.

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Fundamental Analysis Strategy

If technical analysis focuses on "surface patterns," fundamental analysis digs into the "underlying essence."

By deeply researching fundamental factors affecting commodity prices—such as supply-demand dynamics, macroeconomic indicators, and policy shifts—you can forecast price movements and make more informed investment decisions.

Event-Driven Strategy

Event-driven strategies focus on predicting how certain occurrences will affect commodity prices.

In commodity markets, sudden events often trigger sharp price volatility. This strategy leverages such events for speculation.

These events include natural disasters, policy announcements, and major economic data releases.

Example:

In 2023, severe droughts in Brazil caused a significant decline in coffee and soybean crop yields. As coffee is a globally critical agricultural commodity, reduced supply sparked market concerns, driving coffee futures prices sharply higher.

Traders who monitored the drought situation early and bought coffee futures before the price surge could profit from the subsequent upward movement.