When setting up a futures hedge, one of the most crucial decisions you’ll make is selecting the appropriate delivery month for the contract. An often-recommended approach is to choose a delivery month that is as close as possible to—but slightly later than—the end date of the hedge period. This strategy ensures that the hedge covers the entire exposure period without creating gaps or excessive costs. But why exactly is a later-dated contract preferred? Let’s dive into the details.

The Basics of Futures Hedging

Futures contracts are standardized agreements to buy or sell an asset at a specified price on a future date. In hedging, these contracts are used to mitigate risks associated with price movements. For example, if you’re looking to hedge against the price of a commodity for the next three months, you’ll want to choose a futures contract that aligns closely with this period.

While it may seem logical to select a contract that ends exactly when the hedge period ends, choosing a delivery month that extends a bit beyond the hedge period often provides better risk management. This article explores the key reasons why a later-dated contract is generally a better choice.

1. Avoiding Mismatch Risk

One of the primary reasons for choosing a later-dated contract is to avoid a mismatch between the expiration of the contract and the end of the hedge period. If you select a contract that expires before the end of the hedge (for example, choosing a March 31 contract for a hedge that ends on April 15), you may have to close out your hedge early.

When the futures contract expires before the hedge period ends, you lose the protective benefit for any period between the contract expiration and the end of your hedge. In this scenario, any market movements during that unhedged period can affect your position, potentially leading to losses. By choosing a contract that expires after the hedge period (like an April 30 contract for an April 15 end), you ensure continuous coverage throughout the full period of exposure.

2. Minimizing Rollover Costs

Selecting an earlier expiration date than the hedge period end date may mean you’ll need to roll over your futures contract to maintain the hedge until the end. A rollover involves closing out the expiring contract and opening a new one with a later expiration, which can incur additional transaction costs, spread costs, and sometimes even new margin requirements.

For example, if you select a March 31 contract for a hedge that ends on April 15, you may need to roll into an April or May contract to cover the final two weeks. This adds costs that can often be avoided by initially choosing a contract with an expiration date slightly beyond the hedge period. Opting for the April 30 contract from the start allows you to avoid these extra transactions, simplifying the process and reducing expenses.

3. Market Volatility Near Expiration

Futures contracts tend to experience heightened volatility as they approach expiration. This phenomenon, driven by factors like delivery logistics and liquidity shifts, can make it challenging to manage your position effectively if you’re forced to exit right at the end.

If you select a contract that expires after your hedge period, you gain the flexibility to close out the hedge position at a time that suits you, rather than being tied to the often-turbulent days right before expiration. For example, with an April 30 contract for a hedge ending on April 15, you have the option to close out around April 15, thus avoiding potential last-minute volatility.

4. Flexibility for Unexpected Extensions

Hedging needs aren’t always set in stone. Operational delays, supply chain disruptions, or even shifts in demand can sometimes extend the period for which a hedge is needed. By choosing a contract that expires after the anticipated hedge period, you allow yourself a buffer in case the end date shifts slightly.

For instance, if you initially planned for an April 15 end to your hedge but later realize that coverage is needed until April 20, having an April 30 contract in place ensures that you won’t be left exposed. This extra flexibility can be invaluable in situations where market conditions or business operations change unexpectedly.

5. Protecting Against Adverse Price Movements

When you hedge, the goal is to offset price risks as precisely as possible. Choosing a contract that expires after the end of the hedge period ensures you aren’t vulnerable to adverse price movements in the unprotected period that would arise if the contract expired early. If you were to pick a contract that ends before your hedge period concludes, any movement in the market after that contract’s expiration would impact your position directly, potentially undermining the purpose of the hedge.

Choosing a later expiration date offers full protection, ensuring that market volatility doesn’t affect your underlying position during the hedge period.

Conclusion: The Case for a Later-Dated Contract

In futures hedging, timing is everything. Selecting a delivery month that expires just after the end of the hedge period is a strategic choice that allows for complete coverage, minimizes costs, and offers flexibility in a dynamic market environment. While it may seem tempting to match the hedge period exactly, a later expiration date provides peace of mind and ensures that your hedging strategy works as intended.

The next time you set up a hedge, remember that a slight extension in the contract’s expiration can make a significant difference. This approach minimizes risks, reduces rollover costs, and provides flexibility, making it an essential practice for effective risk management in futures hedging.

By implementing this strategy, you can make your hedging approach more robust, ultimately providing better alignment with your financial goals and risk tolerance.