What Is Over-Hedging?
Let me explain over-hedging directly: it's a risk management strategy where you set up an offsetting position that goes beyond the size of your original position. This can lead to a net position that's actually in the opposite direction from what you started with.
You might do this by accident or on purpose, but either way, it's something you need to watch out for.
Key Takeaways
- Over-hedging happens when your offsetting position is larger than the original one you're trying to protect.
- Intended or not, it creates a net position that opposes your initial stance.
- Just like under-hedging, over-hedging is usually an inefficient way to apply a hedging strategy.
Understanding Over-Hedging
When you're over-hedged, the hedge you've put in place covers more than your underlying position. You're essentially locking in prices for extra goods, commodities, or securities that you don't need to protect. This directly affects your ability to profit from your original position, and that's a key point you should consider in your strategies.
Example of Over-Hedging
Take over-hedging in the futures market—it's often about mismatching contract sizes to your actual needs. Suppose a natural gas company signs a January futures contract to sell 25,000 mm British thermal units (mmbtu) at $3.50 per mmbtu. But they only have 15,000 mmbtu in inventory that they're hedging. Now, because of the contract size, they've got excess futures amounting to 10,000 mmbtu.
That extra 10,000 mmbtu exposes the company to risk—it's basically a speculative play if they don't have the goods to deliver when the contract expires. They'd need to buy it on the open market, profiting or losing based on natural gas price movements.
If natural gas prices drop, the hedge covers their inventory, and they profit on the excess by delivering at the higher contract price. But if prices rise, they sell their inventory below market value and pay even more to cover the excess.
Important Note on Over-Hedging
Over-hedging is frequently a mistake, but remember, for many companies, not hedging at all poses a much greater risk.
Over-Hedging versus No Hedging
As the example shows, over-hedging can introduce extra risk instead of eliminating it. It's similar to under-hedging—both are poor applications of hedging. That said, there are cases where a flawed hedge beats having none. In the natural gas case, the company secures its full inventory price but accidentally speculates on the market. In a falling market, over-hedging benefits them, but the critical fact is that without any hedge, they'd face massive losses on all their inventory.
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