Selling Hedge

  

Categories: Derivatives

You own a large warehouse full of pork bellies. You plan to sell them in the near future for a sweet price. But...you start to get worried. There's word that scientists at CalTech have started growing synthetic pork bellies in a lab. They might perfect the process in the near future, and the bottom will drop out of the market.

You need a way to protect yourself against declining prices. Time for a selling hedge.

This process involves selling futures contracts (or options contracts) in order to hedge against a potential drop in the price of an underlying security or commodity (like your pork bellies). The goal is to provide a safety net...to protect yourself against the downside.

Related or Semi-related Video

Finance: What Is a Call Option?25 Views

00:00

finance a la shmoop. what is a call option? option? option, where are you? okay

00:09

yeah yeah. not phone options, call options. and a close but no cigar. a call option [man smokes in a tub of cash]

00:14

is the right to call or buy a security. the concept is easy the math is hard.

00:24

you think Coca Cola's poised for a breakout as they go into the new low

00:30

calorie beverage business. their stock is at 50 bucks a share and you can buy a [man stands on a stage as crowd cheers]

00:35

call option for $1. well that call option buys you the right

00:39

to then buy coke stock at 55 bucks a share anytime you want in the next

00:44

hundred and 20 days. so let's say Coke announces its new sugarless drink flavor

00:48

zero it's two weeks later and the stock skyrockets to fifty eight dollars a

00:53

share. you've already paid the dollar for the option now you have to exercise it. [man lifts weights]

00:59

so you buy the stock and you're all in now for fifty five dollars plus one or

01:04

fifty six bucks a share and your total value is now fifty eight bucks. well you

01:10

could turn around today and sell the bundle that moment, and you'll have

01:13

turned your dollar into two dollars of profit really fast. and obviously had the [equation on screen]

01:18

stock not skyrocketed so quickly well you would have lost everything. still you

01:23

lucked out and now you're sitting on some serious cash, courtesy of your call [two men in a tub of cash]

01:27

options. as for Coke flavor zero turned out to be nothing more than canned water.

Up Next

Finance: What is a Derivative?
23 Views

A derivative of a security is a "something" which derives its value based on the performance of that security... either a put option or a call option.

Finance: What Is a Put Option?
83 Views

What is a put option? A put option is a type of contract that lets the investor sell shares of a stock at a certain price and within a window of ti...

Find other enlightening terms in Shmoop Finance Genius Bar(f)