Naturally long

You can hold a position in a commodity without ever opening a trading account.

A sugar mill has sugar. If sugar gets dearer the mill is better off. If sugar gets cheaper it is worse off. That is a long position in sugar, and nobody bought it.

The workbook puts both sides in one sentence. Any business or value chain participant is naturally short on raw materials and long on finished goods.

So naturally long describes the output side. On finished goods a business gains when their prices gain, and loses on falling prices.

The remedy follows from the direction. A long position is cancelled by a short one. So a producer hedges by selling his finished goods forward, in forwards or futures.

That is a short hedge, and the workbook says hedgers generally hedge by buying raw materials in forwards or futures, selling finished goods in forwards or futures, or both.

The word naturally is doing the work. The exposure came with the business, not from a trade.

The two-sided rule. Commodity users use commodities as a raw material; for commodity producers, the same commodity is a finished good. Any business or value chain participant is naturally short on raw materials and long on finished goods. They gain if raw material prices fall and lose when raw material prices rise; and on finished goods they gain when prices gain and lose on falling prices. The workbook therefore splits hedgers into two broad types — commodity users (processors and consumers) and commodity producers — and notes that hedgers include importers, exporters, producers and processors.

The hedge that cancels it. Hedging means taking a position in the derivatives market that is opposite to the position in the physical market, to reduce or limit the risk of price changes. A naturally long producer therefore sells futures. A short hedge involves the sale of futures to offset potential losses from falling prices.

It works because spot and futures prices tend to move in tandem, closely enough even if not identically, so a loss in the spot market is offset by a gain in the futures market.

The two steps. Hedging is a two-step process. If the hedger plans to sell a commodity in the spot market in future, he sells futures now and then either delivers the commodity against his sell position on the expiry date, or — if he manages to sell in the spot market in the interim — immediately exits the futures position.

One firm can be both at once. A soya crusher is naturally short soybean, which it buys, and naturally long soya oil and soya meal, which it sells. Both exposures are live on the same day, which is exactly the pair that a crush spread trades. The same logic across crude and its refined products is the crack spread.

Sizing the short. The number of lots is not automatically one-for-one. The hedge ratio is the correlation between spot and futures multiplied by the standard deviation of the change in spot price divided by the standard deviation of the change in futures price. The workbook's worked case gives correlation 0.93, spot standard deviation 3.56 and futures standard deviation 3.63, producing a hedge ratio of 0.912 and, on a 50 MT exposure with a 5 MT lot, 9 contracts rather than 10.

The naturally-long sentence itself carries no figure — it is a statement of direction. The figures belong to the worked hedge below it.

The workbook's own short hedge, which is the naturally long case in full.

A guar seed producer wants to sell 1 MT — 10 quintals at Rs 4,000 per quintal at the end of July, to earn his desired profit. He is naturally long guar seed: he has the crop, and a falling price hurts him.

The arithmetic on each leg:

Spot shortfall = (4,000 - 3,950) x 10 = Rs 500 Futures gain = (4,050 - 4,000) x 10 = Rs 500

Net effect nil. The loss in the spot position was offset by the profit in the futures position, and the producer got his Rs 4,000 a quintal after all.

Now the reverse path, which candidates forget. Had guar seed risen to Rs 4,200, the producer would have sold his 10 quintals for Rs 42,000 — Rs 2,000 more than planned — and lost roughly the same on the short futures. The hedge removes the fall and the rise. That symmetry is the cost of being hedged, and it is why an offsetting hedge is a decision about certainty, not about profit.

Scale it up. On 50 MT rather than 1 MT, at the workbook's hedge ratio of 0.912 and a 5 MT lot, the producer sells 9 lots instead of 10 — deliberately leaving 5 MT of his natural long position unhedged, because the ratio says that minimises the variance of the combined position.

Chapter 5 (Uses of Commodity Derivatives), section 5.1 on hedging, where the naturally short and naturally long sentence appears, and section 5.2 on long and short hedge strategies, which works the guar seed short hedge in full. Section 5.2.1 supplies the hedge ratio arithmetic.

Expect a direction question: a business is naturally ____ on its finished goods — long — and the paired remedy, that finished goods are hedged by selling futures. The discriminating version gives you a specific firm and asks which way it is exposed, so read carefully whether the commodity named is that firm's input or its output. The same commodity makes one firm naturally long and another naturally short.

• Naturally long on finished goods, naturally short on raw materials. One sentence, two directions, and swapping them inverts every hedge that follows.
• The hedge for a natural long is a SHORT hedge — selling futures. Buying futures doubles the exposure instead of cancelling it.
• It depends on the firm, not on the commodity. Soybean makes a crusher naturally short and a farmer naturally long. A question naming a commodity without naming the business cannot be answered.
• The same firm can hold both positions at once. A crusher is naturally short its seed and naturally long its oil and meal — which is what the crush spread trades.
• The hedge kills the upside too. The guar seed producer who hedged at Rs 4,050 keeps Rs 4,000 a quintal whether the market falls to Rs 3,950 or rises to Rs 4,200.
• A hedge need not be one-for-one. The workbook's hedge ratio of 0.912 deliberately leaves part of the natural position open.
• Natural exposure is not a derivative position. It carries no margin, no expiry and no contract — which is exactly why it is easy to overlook until prices move.