In this blog of Hedging with Jorge, we move from exercises into action. Jorge walks us through a practical scenario faced by aluminium traders when they are holding physical inventory but want to manage price risks. No numbers this time, just pure conceptual clarity.

Let’s assume you’re a trader who has purchased aluminium, paid for it, and stored it in your yard. The price has been fixed at the time of purchase, which means you are now exposed to a price drop. If the market moves against you, you’re at risk of incurring losses.

Now, you’re not transforming this aluminium; you’re planning to resell it. The catch? Your customer is only willing to fix the premium but not the base metal price. This is where your hedging strategy kicks in.

Say, you’ve bought aluminium at $2,500 and paid a premium of $400. You’ve found a buyer who is ready to pay a premium of $600. Great you’re making a $200 gain on the premium. But what if the market price of aluminium falls? Your premium gain may not be enough to offset the price drop.

In this case, your buyer agrees to fix the aluminium price later, say in August, based on the average LME cash settlement price for that month. That means your final invoice price will only be known once August ends and the LME average for the month is published.

So, how do you manage this uncertainty?

You duplicate the transaction on the LME.

While you sell the aluminium to your customer with a fixed premium and floating price, you simultaneously sell the same quantity on the LME’s Monthly Average Futures Contract. This locks in the price based on the average LME cash price of August, the same mechanism your invoice will follow.

When August ends, the LME calculates the average cash settlement price. You buy back your position on the LME at this price. Let’s say the average turns out to be $2,000. You invoice your buyer using this price, and even though it looks like a loss ($2,500 purchase vs $2,000 sale), you’ve actually made $500 from the LME hedge.

In the end, the price risk is neutralised, and you still retain your premium profit. That’s the beauty of a perfect hedge, zero price risk, full control and a protected bottom line.