In finance, a long hedge is an investment technique that allows an investor to protect herself against losses by locking down an agreed-upon price for a commodity purchased in the future, in an agreement known as a futures contract. A futures contract is an arrangement for an investor to buy a commodity at a specified price on a set date. When an investor buys or sells an investment in order to protect herself against price changes, she is hedging. The long hedge is in contrast with the short hedge, in which an investor sells borrowed securities or futures in commodities she does not yet have.
When an investor takes a long position, this means that she has purchased a security in hopes of profiting from rising prices. A long investment is essentially a bet that the price of the investment will go up by the end of the contract, called the delivery date. If the price goes up, the investor profits from the price difference. Falling prices mean the investor loses by having paid a higher price for a lower valued commodity or stock that she could have purchased at the lower price. An investor making a long hedge investment is making a long investment to offset potential losses in other investments, which may include securities or a business owned by the investor.
Often, a long hedge is used by business owners who wish to lock in costs for fulfilling a contract that needs to be fulfilled in the future. If in March a pie shop owner gets a contract for apple pies with the delivery date in November, the pie shop owner can purchase futures in apples to protect against rising apple prices when the time comes for the pies to be made. By locking in a price for the apples now, the shop owner is ensuring that price changes in apples will not affect her profit on the apple pies, but if the apple price drops lower than that at which the shop owner agreed to buy the apples, she loses out on the discount. Even if the price of a long hedge investment does not work out in the apple pie shop owner's favor, she still benefits from the stability of a steady apple price upon which she can base cost estimates for the business.
The short hedge is used to offset projected losses in long-term investment contracts. A correctly designed short hedge can zero out losses incurred in long term investments. When an investor shorts in the stock market, the investor is borrowing stock from a broker to sell with the agreement that the investor will buy the stock on a predetermined date. Investors who work with short investing are betting that the price of the shorted commodity or stock will fall. If the price of the security goes up, the investor loses money because she then has to pay the higher price for securities sold earlier at a lower price.
