Let’s break down the concept of hedging, especially in the context of aluminium trading, in a clear and simple way.

Stepping into the shoes of a hedger:

Imagine you’re someone who uses aluminium in your business. Naturally, you’d buy aluminium from your regular supplier. But what if your supplier can’t give you a fixed price today for something you’ll need in July? That’s where hedging comes in.

You know how a futures market works – you can either buy (go long) or sell (go short) aluminium for a future date. The big question is: why would someone buy aluminium on the futures market instead of from their usual supplier?

When your supplier can’t fix the price:

Often, your supplier isn’t trying to be difficult – they simply can’t fix a price right now. They can only offer a price that will be based on a future market value, plus a premium (an extra cost added on top).

Let’s say today is May. You’ve already sold your aluminium-based product to a customer at a fixed price for delivery in July. But your supplier tells you they can only give you the aluminium at a floating price that will be determined on the third Wednesday of July.

Now you have a problem:

You are selling your product at a fixed price.

You are buying your raw material (aluminium) at a floating price.

This mismatch creates risk. If aluminium prices rise by July, your costs go up — but your selling price stays the same. That’s a potential loss.

How the futures market helps:

This is where the London Metal Exchange (LME) steps in through a broker. It says:
“Hey, I can help. You can buy aluminium from me today, for delivery on the third Wednesday of July — just like your supplier’s floating price.”

You might wonder, “So now I’m buying aluminium twice?”
Well, kind of — but only one is physical. The LME lets you buy financially — it’s called cash settlement.

When July arrives, you don’t actually collect any metal from the LME. Instead, you simply sell the futures contract back. The difference in price between what you bought it for and what it’s worth in July covers any increase in your physical aluminium cost.

What’s the point?

You’re using the futures market to lock in a price and protect yourself from price increases. If the price goes up in July, your LME futures contract pays you the difference — and that covers the extra cost from your supplier. This is the essence of hedging.

It may sound tricky at first, but once you get the hang of it, it’s like riding a bike — it just clicks.

Final note

This explanation gives you the logic behind hedging. In the next session, we’ll look at some numerical examples to see how it works in real life. If you want to get a head start, try doing the math yourself using this scenario — it’s a great way to understand how hedging can protect your business.