A hedging example

The primary thrust of this book is geared toward the speculator and how he can use the commodity futures and options markets to make money. However, it is important for all traders to understand how a typical hedge might work to see why these markets exist in the first place. Remember, the perfect hedge is rare; there is just about always some basis risk. However, the concept is the same regardless of whether we are discussing a packing plant hedging its live cattle needs or a bank hedging its interest rate risk. Hedges come in two basic forms: the short and the long.

The short hedge

A short hedge is entered into to protect the value of an inventory. Consider an example using crude oil. An inventory of 1,000 barrels of crude ...

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