In this episode of Hedging with Jorge, we dive into the practical application of short hedging in the futures market using a real-world aluminum scenario. Jorge walks us through how a physical sale, when paired with a futures market hedge, can protect against falling prices and secure a positive financial outcome.

The Scenario: Physical purchase and sales risk

Let’s set the stage. You purchase 200 tonnes of aluminium at a fixed price of $2,500 per tonnes on May 28. This material is then stored while you await confirmation from your customer. The customer commits to purchasing the same 200 tonnes but is unable to lock in the price at the time. The sale price will be determined later specifically, on July 16.

Now, this delay creates exposure to price volatility. The primary risk? Aluminum prices might fall by July 16. If you do nothing, any drop in price means a direct financial loss when invoicing your customer.

Enter the LME: A solution through futures

To mitigate this risk, Jorge suggests using the London Metal Exchange (LME) to create a short hedge. Since one LME contract represents 25 tonnes, you enter into 8 short contracts equivalent to your 200 tonnes physical holding. You sell these futures contracts on the LME for July 16 delivery, locking in the prevailing futures price of $2,507.

At this point, you’ve:

Bought physical aluminum at $2,500

Agreed to sell to a customer at an unknown price (to be fixed on July 16)

Entered a hedge by selling 8 LME contracts at $2,507

This results in a preliminary gain of $7 per ton from contango where futures prices are slightly higher than spot prices. That’s $1,400 in your favour, on paper.

Final price discovery and settlement

On July 16, your customer finally fixes the price at $2,490 per tonnes. You issue the invoice at this lower price, which implies a $10 loss per tonne compared to your original purchase cost. However, here’s where the hedge works in your favour.

You now buy back your LME contracts at $2,490 the same price as the customer invoice. This results in a $17 gain per ton from the futures position. Offset this against your $10 physical loss, and you’ve netted a $7 gain per ton overall.

By aligning the LME hedge with the customer’s price discovery date, you protect your bottom line even when physical prices fall.