NISM Series XVI · Chapter 5: Uses of Commodity Derivatives

L1 · Foundation

Foundation — Hedging: who hedges, why and how

Hedging as taking an opposite position in the derivatives market; the two types of hedgers and why every value chain participant is naturally short raw materials and long finished goods; the two-step process; offsetting hedges versus locking in an attractive price; hedging through call and put options including the cotton merchant illustration and the MSP parallel; worked long hedge and short hedge examples in gold and guar seed; and the two benefits and five limitations of hedging.

21 min read · Worth 15% of the paper · Written from pages 93–118 of the official NISM workbook · Updated 18 September 2026

Hedging — price risk management

1. What hedging is

⚠️ "Hedging is a process designed to REDUCE OR REMOVE THE RISK OF A PRICE CHANGE arising from a position in an asset in the spot market or a position in the derivative market. A HEDGER ENTERS INTO THE DERIVATIVES CONTRACT TO MITIGATE THE RISK OF ADVERSE PRICE FLUCTUATION IN RESPECT OF HIS EXISTING POSITION."

⚠️ "Hedgers HAVE AN UNDERLYING EXPOSURE IN THE COMMODITY and use the derivatives market to INSURE THEMSELVES AGAINST ADVERSE PRICE FLUCTUATIONS. Hedgers include IMPORTERS, EXPORTERS, AND PRODUCERS AND PROCESSORS."

1.1 The two types of hedgers

⚠️ "Commodity users USE COMMODITIES AS A RAW MATERIAL, while for the commodity producers, IT IS FINISHED GOODS."

⚠️ "Hence, hedgers generally hedge by BUYING RAW MATERIALS IN FORWARD/FUTURES OR SELLING FINISHED GOODS IN FORWARDS/FUTURES OR BOTH. Thus, HEDGING IS A TOOL FOR 'COMMODITY PRICE RISK MANAGEMENT'."

Read the phrase "naturally short" carefully — it does not mean the business has sold anything. It means it must buy in future, so a price rise hurts it exactly as a short position would. The hedge simply cancels that natural exposure.

2. Hedging is a two-step process

If the hedger plans to BUY in the spot market later:

⚠️ "He BUYS THE FUTURES CONTRACT NOW. This is the first step."
⚠️ "Subsequently, HE TAKES THE DELIVERY AGAINST HIS FUTURES POSITION ON THE EXPIRY DATE."
⚠️ "Alternatively, if the hedger MANAGES TO BUY the required commodity from the spot market in the interim, HE MAY SQUARE OFF HIS FUTURES CONTRACT."

If the hedger plans to SELL in the spot market later:

⚠️ "He will SIMULTANEOUSLY SQUARE OFF THE FUTURES POSITION."
⚠️ "Alternatively, he may DELIVER THE COMMODITY AGAINST HIS SELL POSITION on the expiry date."
⚠️ "Alternately, if the hedger MANAGES TO SELL the commodity in the spot market in the interim, THEN HE IMMEDIATELY EXITS HIS FUTURES POSITION."

2.1 Why it works at all

The words "not necessarily identical" carry a whole risk in them. That gap is basis risk, and it is why a hedge reduces price risk rather than abolishing it.

3. The two basic hedging strategies

Strategy	⚠️ What it does
⚠️ OFFSETTING HEDGE	"Hedges undertaken to OFFSET PRICE RISK THAT HAS ARISEN OVER A PHYSICAL MARKET ACTIVITY THAT HAS ALREADY BEEN UNDERTAKEN"
⚠️ LOCKING IN A PRICE	"Hedges can serve to LOCK IN AN ATTRACTIVE PRICE LEVEL from a transaction by FIXING THE SALES PRICE AT A LEVEL ABOVE THE KNOWN COSTS (in the case of a seller), or FIXING A PURCHASE PRICE AT A LOWER LEVEL (in the case of a buyer)"

Two illustrations of the second: ⚠️ "A PROCESSOR LOCKS THE RAW MATERIAL PURCHASE PRICE for the stocks to be used in his manufacturing process for the NEXT 3 TO 6 MONTHS." And ⚠️ "during SOWING SEASON, FARMERS LOCK IN THE SELLING PRICE of the upcoming harvesting season for their produce, EVEN THOUGH THE PRODUCE WILL BE HARVESTED AND DELIVERED A FEW MONTHS LATER."

4. Hedging with options

4.1 The call option as insurance

⚠️ Features: "It is THE RIGHT, BUT NOT THE OBLIGATION, TO BUY a specific commodity at the strike price at a specified time in future. IN PURCHASING A CALL OPTION, THE BUYER IS EFFECTIVELY BUYING INSURANCE AGAINST HIGHER PRODUCT PRICES in the spot market on the specified future date. The buyer PAYS AN UPFRONT PREMIUM."

⚠️ Benefits: "PROTECTION FROM ANY PRICE APPRECIATION IN THE SPOT MARKET ABOVE THE STRIKE PRICE. In case of a price increase, THE LOSS IS COMPENSATED BY THE GAINS FROM THE POSITION TAKEN IN THE OPTION MARKET."

"For example, if you buy a call option of strike price Rs 1,000 and on expiry the spot price is Rs 1,700, you can exercise this contract AT A PROFIT OF Rs 700. Thus, hedging comes in the form of PRICE PROTECTION where THE MAXIMUM LOSS FOR A BUYER OF AN OPTION CONTRACT IS LIMITED TO THE OPTION PREMIUM PAID."

⚠️ Disadvantages: "The buyer has to PAY AN UPFRONT PREMIUM." And a subtler one — ⚠️ "OPTION PRICE (PREMIUM) MOVEMENT IS NOT LINEAR to underlying commodity price. Hence, HAVING A PERFECT HEDGE VIA OPTIONS IS DIFFICULT, AS IT REQUIRES TECHNIQUES OF GAMMA HEDGING ALSO. As the rate of change in an option's price is NOT A STRAIGHT LINE BUT IN CURVATURE, HEDGING ALSO REQUIRES CONSIDERATION OF THE GAMMA FACTOR APART FROM DELTA ALONE."

4.2 The cotton merchant illustration

"On JANUARY 1, a merchant enters into a FORWARD CONTRACT FOR SALE of 1,000 BALES OF COTTON LINT to a mill at Rs 18,000 PER BALE for delivery in the FIRST WEEK OF APRIL. The merchant is UNWILLING TO BUY 1,000 BALES IMMEDIATELY AND STORE IT to save expenses on storage. HE EXPECTS A DECLINE IN THE COTTON PRICE IN MARCH and HE WANTS TO AVOID THE RISK OF UNFORESEEN PRICE RISE AS WELL."

⚠️ "He therefore hedges his forward sale by BUYING A CALL OPTION maturing on MARCH 31 at a PREMIUM OF Rs 500 PER BALE with a STRIKE PRICE OF Rs 17,500 PER BALE."

⚠️ Outcome A — price falls: "Assume the spot price of cotton DECLINES TO Rs 16,000 per bale on March 31 when the merchant buys physical cotton to meet his forward sale commitment. THE MERCHANT NEED NOT EXERCISE HIS CALL OPTION BUT LOSES THE PREMIUM, AND YET MAKES A NET GAIN OF Rs 1,500 PER BALE (Rs 18,000 − Rs 16,000 − Rs 500 premium)."

⚠️ Outcome B — price rises: "Had the spot cotton price RISEN TO Rs 19,000 per bale on March 31, and the settlement price was Rs 19,500 on expiry, THE MERCHANT WOULD HAVE EXERCISED THE CALL OPTION AND TAKEN DELIVERY of the underlying for delivery against his forward sale commitment."

This is what the merchant bought for Rs 500: he keeps the benefit of a falling market and is protected against a rising one. He gave up exactly Rs 500 per bale of his upside to remove an unlimited risk.

4.3 The put option and MSP

⚠️ "MINIMUM SUPPORT PRICE (MSP) declared by the Government for its procurement can be considered EQUIVALENT TO THAT OF WRITING A PUT OPTION FOR THE FARMERS."

"Maize: Rs 1,850 per quintal (previous year Rs 1,760). Wheat: Rs 1,925 per quintal."

⚠️ "For farmers, these MSP acts like THE STRIKE PRICE OF A PUT OPTION. Farmers have the RIGHT TO SELL their produce at that price to the Government IF THE MARKET PRICE IS LOWER. Farmers will have a position like BUYERS OF PUT OPTION at a strike price of MSP."

⚠️ "If MSP = Rs 1,850 and market price = Rs 1,350, farmers will SELL TO GOVERNMENT AT Rs 1,850 instead of selling in the market at Rs 1,350. The government, LIKE A PUT OPTION SELLER, HAS TO TAKE DELIVERY at Rs 1,850. If the actual market price goes ABOVE MSP (say Rs 2,000), THE FARMER MAY NOT EXERCISE this option but MAY SELL IN THE SPOT MARKET."

5. Long hedge and short hedge

⚠️ LONG HEDGE: "The hedger DOES NOT OWN THE UNDERLYING COMMODITY, BUT HE NEEDS TO ACQUIRE IT IN THE FUTURE. He can LOCK-IN THE PRICE that he will be paying in the future BY BUYING, OR GOING LONG IN FUTURES CONTRACTS. In effect, he is ALREADY NATURALLY SHORT on the underlying commodity because HE MUST BUY IT IN FUTURE, and he OFFSETS THIS NATURALLY SHORT POSITION BY TAKING A LONG POSITION IN FUTURES."

⚠️ SHORT HEDGE: "Involves SALE OF FUTURES TO OFFSET POTENTIAL LOSSES FROM THE FALLING PRICES."

5.1 Long hedge — the jeweller

Date	Spot Market	Futures Market
1st June	"A jeweller needs to buy 1 KG OF GOLD at end-July at Rs 50,000 PER 10 GRAMS to make desired profit, and makes a provision for Rs 50.00 LAKHS"	⚠️ "August Futures is trading at Rs 50,400 per 10 grams. HE BUYS ONE AUGUST GOLD FUTURES CONTRACT at Rs 50,400 (1 contract = 1 kg)"
30th June	"Gold is trading at Rs 51,600 per 10 grams. The jeweller PAYS Rs 51.60 LAKHS to buy one kilo gold"	⚠️ "August futures is trading at Rs 52,000. He SELLS at Rs 52,000 and squares off, MAKING A PROFIT OF Rs 1,60,000"
Result	⚠️ HIGHER COST in the spot market: Rs 1,60,000	⚠️ PROFIT in the futures market: Rs 1,60,000

5.2 Short hedge — the guar seed producer

Date	Spot Market	Futures Market
1st June	"A producer likes to sell 1 MT (= 10 QUINTALS) of guar seeds at Rs 4,000 PER QUINTAL at end-July"	⚠️ "He GOES SHORT for 1 lot of August futures (1 lot = 1 MT = 10 quintal) at Rs 4,050 PER QUINTAL"
30th July	"Spot price DROPS TO Rs 3,950 and the producer sells 10 quintals at Rs 39,500"	⚠️ "He BUYS BACK the 1 MT August futures at Rs 4,000 per quintal"
Result	⚠️ LOWER realized price: LOSS OF Rs 500	⚠️ Futures market PROFIT Rs 500

Note the honest imperfection built into both illustrations. The jeweller's futures moved Rs 1,600 while spot moved Rs 1,600 — a clean offset. But in a real market the two rarely move by exactly the same amount, and that difference is basis risk.

6. Benefits and limitations

⚠️ BENEFITS:

⚠️ "PRICE RISK IS MINIMIZED"
⚠️ "PROVIDES FOR ADVANCE PRODUCTION/BUSINESS PLANNING AND CASH FLOW MANAGEMENT"

⚠️ LIMITATIONS:

⚠️ "PRICE RISK CANNOT BE FULLY ELIMINATED"
⚠️ "BASIS RISK CONTINUES TO REMAIN"
⚠️ "TRANSACTION COST IS TO BE INCURRED"
⚠️ "MARGIN IS TO BE MAINTAINED, LEADING TO CASH FLOW PRESSURES"
⚠️ The subtle one — SELECTIVE HEDGING

This is the most important sentence in the chapter for anyone who will actually advise a business. The moment you decide when to hedge, you have stopped hedging and started speculating — you have simply moved the bet from the commodity to the timing.

Think of it like this

The shopkeeper who is short of what he has not yet bought

A dosa hotel owner in Coimbatore has not sold a single grain of rice short. Yet if rice prices double next month, he loses — because he must buy rice next month to stay open.

⚠️ This is what the workbook means by "naturally short": "Any business or value chain participant are NATURALLY SHORT ON RAW MATERIALS AND LONG ON FINISHED GOODS. They GAIN IF RAW MATERIAL PRICES FALL and they LOSE WHEN RAW MATERIAL PRICES INCREASE."

So he offsets it: in a long hedge, "the hedger does not own the underlying commodity, but he needs to acquire it in the future... In effect, HE IS ALREADY NATURALLY SHORT because HE MUST BUY IT IN FUTURE, and he OFFSETS THIS NATURALLY SHORT POSITION BY TAKING A LONG POSITION IN FUTURES."

The useful discipline here is to ask, of any business: what price movement would hurt it even if it did nothing at all? That answer is its natural position, and the hedge is always its mirror.

Two sides of a weighing scale

Put a one-kilo weight on the left pan and the scale tilts. Put a one-kilo weight on the right pan and it settles level. Neither weight has vanished — they simply cancel.

⚠️ A hedge is exactly this. "Taking opposite positions in the spot and futures market ALLOWS LOSSES IN ONE MARKET TO BE OFFSET BY GAINS IN THE OTHER."

The jeweller's numbers show it working: he paid Rs 1,60,000 more for his gold in the spot market, and made Rs 1,60,000 profit on his futures. "The loss in the spot position was offset by the profit made in the futures position."

But look closely at the two pans. If the futures weight were 990 grams instead of 1,000, the scale would still tilt slightly. That residual tilt is basis risk, and it survives every hedge — which is why the workbook lists "price risk cannot be fully eliminated" and "basis risk continues to remain" among the limitations.

Health insurance you renew every year, not only when you feel unwell

Nobody buys a mediclaim policy only in the months they expect to fall ill. If they could time illness that accurately, they would not need insurance — they would need a doctor's licence.

⚠️ This is the workbook's warning about selective hedging: "If hedging is SELECTIVELY CARRIED OUT ON A FEW POSITIONS BASED ON ONE'S VIEW and not on other positions, THE HEDGING TRANSACTION LEG ITSELF MAY RESULT IN LOSS... This is because SELECTIVE HEDGING, WITH THE CHOICE TO HEDGE OR NOT TO HEDGE, IS AS GOOD AS SPECULATION OR TRADING THE COMMODITY."

The moment a mill decides when cotton looks expensive, it has stopped hedging and started trading cotton — with the whole company as collateral. The bet has simply moved from the price to the timing.

Buying and selling the same vegetable in two mandis at once

A trader sees tomatoes at Rs 20 a kilo in the Coimbatore mandi and Rs 26 in Erode, forty minutes away. He buys in one and sells in the other at the same moment. His profit does not depend on what tomatoes do tomorrow — it was locked the instant both trades printed.

⚠️ "ARBITRAGE INVOLVES MAKING PURCHASES AND SALES SIMULTANEOUSLY IN TWO DIFFERENT MARKETS to profit from the prevailing price differences." And "the factors driving arbitrage are THE REAL OR PERCEIVED DIFFERENCES IN THE EQUILIBRIUM PRICE as determined by supply and demand AT DIFFERENT LOCATIONS."

⚠️ The purity test is strict: "ARBITRAGE STRATEGY DOES NOT TAKE ANY BASIS RISK. IF BASIS RISK EXISTS because of uncertainties of reversal or roll-over, then those are, in fact, NOT PURELY AN ARBITRAGE POSITION BUT A BET ON SPECIFIC DIFFERENCES."

That last sentence disqualifies most of what traders casually call arbitrage. If either leg can move without the other, you are not arbitraging — you are betting on a spread.

Renting out the terrace of a house you are not selling

You own a house you intend to keep. A mobile tower company offers rent for terrace space. You collect income from an asset you are holding anyway — but if you ever want to sell in a hurry, the tenancy complicates it.

⚠️ That is a covered call. "A COVERED SHORT CALL POSITION IS CREATED BY COMBINING A LONG UNDERLYING POSITION WITH A SHORT CALL OPTION. A covered call option ATTEMPTS TO ENHANCE THE RETURN IN A STAGNANT MARKET and at the same time PARTIALLY HEDGE A LONG UNDERLYING POSITION."

⚠️ And the crucial contrast: "Covered short call is DIFFERENT FROM A NAKED SHORT CALL. A NAKED SHORT CALL IS A SPECULATIVE POSITION WHERE THE INVESTOR DOES NOT OWN THE COMMODITY."

The nickel stockist who writes a Rs 1,025 call on stock he holds is renting out his terrace. Somebody who writes the same call with no nickel has sold a terrace on a house he does not own — and may have to buy the house at any price to deliver it.

Betting that the ball will move, without saying which way

Before a Test match on a fresh green pitch, a spectator says: "I don't know who wins, but this will not be a dull draw." He is betting on movement, not on direction.

⚠️ That is a long straddle. "A LONG STRADDLE is an option strategy where the trader BUYS A CALL AND A PUT WITH THE SAME STRIKE PRICE AND SAME EXPIRY DATE by paying premium." Its market view is simply "AN INCREASE IN VOLATILITY."

The workbook's aluminium numbers: buy the 190 call at Rs 12 and the 190 put at Rs 13, total Rs 25. If aluminium rises to 230, exercise the call for Rs 40 and net Rs 15. If it falls to 150, exercise the put for Rs 40 and net the same Rs 15. Anywhere in between, he loses part of the Rs 25.

⚠️ A strangle is the cheaper version: "purchase of a call and put with the SAME EXPIRY DATE BUT WITH DIFFERENT STRIKE PRICES", whose premium cost is "LOWER, as it is expected that the buyer is ready to bear part of volatility within the range of two strikes."

You pay less, and in exchange you need a bigger move before you start earning.

Key terms in this chapter

Arbitrage: Simultaneous purchase and sale in two different markets to profit from a price difference. True arbitrage takes no basis risk — where basis risk exists from uncertainties of reversal or roll-over, the position is a bet on a spread, not arbitrage.
Basis: Spot price minus futures price. Negative basis means futures above spot, which is contango; positive basis means futures below spot, which is backwardation. Basis narrows to zero at expiry in both.
Basis risk: The risk that a futures price moves differently from its underlying asset. The best method of eliminating it is to hold the futures contract till expiry, when the two prices converge.
Buying a spread: Buying the near-month contract and selling the far-month contract, when the near month is underpriced or the far month overpriced.
Cash and carry arbitrage: Buying a physical commodity with borrowed funds and simultaneously selling futures, then delivering at expiry. It arises when the futures price exceeds spot plus cost of carry.
Covered short call: A long underlying position combined with a short call, to enhance return in a stagnant market and partially hedge the holding. Distinct from a naked short call, where the writer owns nothing and is purely speculating.
Covered short put: Selling a put while holding sufficient funds to buy the commodity if assigned. Selling a put without those funds is a naked short put, which is a speculative position.
Crack spread: The energy complex spread — trading crude oil against the petroleum products extracted from it, to lock refining margins.
Crush spread: The soyabean complex spread — buying soyabean while selling soyabean meal and soyabean oil in a fixed proportion, to lock processing margins.
Diagonal spread: Buying and selling options with different strike prices AND different expiry months, to trade both a market view and a change in volatility.
Futures bear spread: Created when the actual spread is below the fundamental average difference, expecting it to widen. Sell the near month and buy the far month.
Futures bull spread: Created when the actual spread exceeds the fundamental average difference between two calendar months, expecting it to narrow. Buy the near month and sell the far month.
Hedge ratio: The correlation between spot and futures multiplied by the ratio of their standard deviations. It tells the hedger how many lots to trade, and can be above or below one — matching quantity does not match risk.
Hedging: Taking a position in the derivatives market opposite to a position in the physical market, so that a loss in one is offset by a gain in the other. It reduces price risk but never abolishes it.
Hedging disclosure norms: SEBI's circular of 15 November 2018, following the Uday Kotak Governance Committee, requiring listed companies to disclose commodity risk management policies and, for each commodity, the exposure and the extent hedged — domestic and international, OTC and exchange, separately.
Horizontal spread: Also called a calendar spread — same strike price, different expiry months, used to trade volatility. Selling the short maturity and buying the long one profits if volatility falls; the reverse profits if it rises.
Inter-commodity spread: Long one commodity and short a different but economically related one, in the same calendar month — guar seed against guar gum, or soyabean against soya oil.
Intra-commodity spread: Also called a calendar spread — long one month and short another month of the same underlying. Settlement default risk is low, so margins are low.
Locking in a price: The other basic hedging strategy — fixing a sales price above known costs, or a purchase price at a lower level, ahead of the transaction. A processor locking raw material cost for three to six months, or a farmer fixing a selling price during sowing season.
Long hedge: Buying futures to lock in a future purchase price when the hedger does not yet own the commodity. It offsets a naturally short position and benefits when the basis weakens.
Long speculator: One who buys first and expects the price to rise. A long speculative transaction is a futures purchase without any corresponding short position in spot.
Long straddle: Buying a call and a put at the same strike and expiry, betting on an increase in volatility without a view on direction. Risk is the total premium paid; reward is unlimited.
Long strangle: Buying a call and a put with the same expiry but different strikes. Cheaper than a straddle, because the buyer accepts part of the volatility within the range between the two strikes — so a larger move is needed to profit.
Naturally long: The position a business holds in its finished goods — it gains when their prices rise and loses when they fall, which is why finished goods are hedged by selling futures.
Naturally short: The position every business holds in its raw materials — it must buy them in future, so a price rise hurts it exactly as a short position would. A long hedge cancels this exposure.
Offsetting hedge: A hedge undertaken to offset price risk arising from a physical market activity that has already been carried out.
Reverse cash and carry arbitrage: For a holder of the asset — selling the commodity in the spot market, lending the proceeds and buying futures. It arises when the futures price is below spot plus cost of carry.
Selective hedging: Hedging only some positions based on a market view. The workbook warns this is as good as speculation, because choosing when to hedge is itself a bet — which is why a business focused on its core competency hedges incidental risks at all times.
Selling a spread: Selling the near-month contract and buying the far-month contract, when the near month is overpriced or the far month underpriced.
Short hedge: Selling futures to offset potential losses from falling prices on stock held or goods yet to be manufactured. It benefits when the basis strengthens.
Short speculator: One who sells first and expects the price to fall. A short speculative transaction is a futures sale without any corresponding long position or stock in hand.
Short straddle and strangle: Selling both legs, betting that volatility will fall. Maximum reward is the premium received and maximum risk is unlimited. A short strangle writer typically sells out-of-the-money strikes to reduce the chance of exercise.
Speculation: Trading to make quick profits from price fluctuations, with no intention of physical use. A speculative transaction is defined by having no corresponding position in the spot market.
Spot versus futures arbitrage: Trading the gap between the fair futures price and the traded futures price. Buying gold at Rs 50,000 against a fair value of Rs 50,700 and selling futures at Rs 51,200 yields a riskless Rs 500 per 10 grams.
Spread: The difference in prices between two futures contracts — two months of the same commodity, or two economically related commodities. A spread trader profits from the change in the relative value of the two legs.
Spread margin benefit: Under SEBI's March 2023 circular, up to 75 percent of total initial margin for the same underlying commodity and up to 50 percent for two different commodities correlated at 0.90, limited to the first six expiring contracts, with extreme loss margin still applying to each leg.
Strengthening basis: Basis becoming more positive or less negative — associated with spot rising and futures falling. It benefits the short hedger, in both contango and backwardation.
Vertical spread: Buying and selling options with different strike prices but the same expiry, to trade a moderately bullish or bearish view. Bull spreads buy the lower strike and sell the higher; bear spreads do the reverse.
Weakening basis: Basis becoming less positive or more negative — associated with spot falling and futures rising. It benefits the long hedger, in both contango and backwardation.

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Original explanatory writing based on the official NISM workbook for Series XVI, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

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