Back in mid-2008, gasoline prices rose above $4.00/gal in some parts of the Nation. I immediately started to look for ways to hedge my gasoline costs. I discovered a company called MyGallons that allows its members to essentially buy electronic gallons of gasoline and trade them in as prices go higher. I became a member, but by the end of 2008, gasoline prices were trading below $2.00/gal and I totally forgot about the idea, and never actually used the service. Then in the Summer of 2012, gas prices again cracked $4.00/gal, and this concept re-emerged, but I wasn't going to hedge gas prices over $4.00/gal. Reviewing the gas chart was like a punch in the gut as I realized the opportunity I missed in late 2008. I swore if gas prices ever got down that low again I would lock in that price for a decade, and here is the strategy I've designed.
Part #1: Background:
1) The instrument to be used in the United States Gas Fund, LP (UGA), an ETF that specifically targets wholesale gasoline, specifically NYMEX New York Harbor RBOB, which is a far better hedge than using crude oil or other proxies. It is wholesale vs. retail, so it isn't a perfect hedge, but it is the best of the alternatives.
2) I currently spend about $7,500 on gasoline per year, about $3,500/yr using the low price set in 2008. Personally, I was shocked when I calculated that number and double and triple checked that number. I would have estimated my family's gas expense at half of what it actually is.
3) Currently the standard deviation of UGA is about 2% per month.
4) Call options one month out and 2 standard deviations above the current price (March 2013 $67 Call) trade for $0.40, or 0.62% of the current price. That works out to be about 7.5% on an annual basis. I chose 2 standard deviations to minimize the chance of the strike price being reached and the ETF being called away, thus reducing the effectiveness of the hedge.
Part #2: The Plan: Purchase enough UGA to hedge a decade of gasoline consumption:
To hedge a decade of gasoline consumption would take $35,000 if the prices got back down to the 2008 low. Currently with rates so low, I would most likely use my line of credit, but be prepared to pay it off in full if rates increase. I would then write calls off the full $35,000 for an estimated amount of $2,500/yr. That amount would be used to pay for transaction costs, interest on the line of credit and taxes on the capital gains. Then on an annual basis, I would sell enough of my holding to pay off my past year's gasoline bill. You could do this on a more frequent basis, but the transaction costs would be higher. This strategy works well if you have loss-carry-forwards or withdrawing money from a Roth IRA. If you don't have losses to carry forward, you have to adjust the amount of the initial purchase to cover the taxes as well.
With the plethora of new ETFs and ETNs, this strategy can be applied to many other everyday household costs.
Part #3: The Strategies: If you buy it on a regular basis, learn to hedge it:
1) If you heat your house with heating oil, the United States Diesel Heating Oil Fund (UHN) can be used to hedge your home heating expense. If you use natural gas, you can use United States Natural Gas Fund (UNG). If a seasonality pattern develops, you would go long in summer to lock in the low prices and sell in winter when prices are highest.
2) If you want to hedge your food and beverage costs, you can use iPath Pure Beta Coffee (CAFE) to hedge your coffee and iPath Pure Beta Livestock (LSTK) to hedge your meat expenses. Healthy rain season in Brazil, buy CAFE, drought in Brazil sell CAFE. Ethanol mandate is lowered, grain prices fall, cattle prices fall, go long LSTK. Drought in the mid-west or ethanol mandate increased, sell LSTK.
3) If you just sold your house, aren't ready to buy another one, but want to lock in the current low rates, you could take the proceeds of your house and buy a fund like ProShares Short 20+ Year Treasury (TBF). This fund effectively allows you to go long interest rates. This strategy assumes that you would plan on getting a long-term fixed rate mortgage. I'll go into more details about this strategy in another article. The key is to match the duration of your mortgage, which is beyond the scope of this article.
4) If you are nervous about the stock market, but don't want to sell your stocks and pay the capital gains taxes, you could hedge your holdings with the ProShares Short S&P 500 Fund (SH). I'll go into more details about this strategy in another article. The key is to match the beta of your portfolio, which is beyond the scope of this article. There are also funds that go long volatility and track the VIX and similar indexes, but those are beyond the scope of this article as well.
I could continue on, but the possibilities are limitless with new ETFs and ETNs are coming to the market seemingly on a daily basis. Here is a list of the available ETFs and ETNs, which you can read through and mix and match them to suit your individual lifestyle. Small businesses can also use them if their needs aren't large enough to justify using the futures markets.
Part #4: Nobody's perfect: None of these strategies are perfect hedges:
1) Many of the funds use futures that track the spot price, not the retail price in your locality. The spot price doesn't always perfectly track the local retail price.
2) Some of the funds consist of more than a single commodity. The livestock ETF hedges a 65/35 mix of beef and pork. If all you eat is bacon, 65% of the hedge will be ineffective.
3) The funds have expense ratios and tracking errors that reduce the effectiveness of the hedge.
4) Depending on your frequency of trading, transactions costs can eat up much of the benefits of the hedge.
Part #5: Word of caution: Murphy's Law:
1) Timing the market is extremely difficult, the markets often go against the hedge. I thought the 10-year Treasury rate couldn't possibly go below 2.25%. Rates can't go below the rate of inflation I was always taught. I put 100% of my work 401-k into the ProShares UltraShort 20+ Year Treasury (TBT) without telling my wife. She just discovered my statement and made very clear to me that rates can and did go below 2.25%. I now sleep on the couch and eat Raman noodles for dinner. Being wrong on a hedge can seriously alter the quality of your life. That last part is a joke, but you should be mentally and financially prepared for the hedge to go wrong, even if all that happens is you miss out on gains.
2) Tastes may change. If you hedge your expected pork and beef consumption, but suddenly have quadruple bypass surgery and have to go on a no beef and pork diet, you are effectively long livestock and no longer hedging your consumption.
3) The ETF or ETN you are using may close, and you may be forced to exit your hedge at a very inconvenient time. Imagine having put the gasoline hedge on in July of 2008 when prices were over $4.00/gal and being forced out in December 2008 when gasoline prices were below $2.00/gal. You just locked in an additional $2.00/gal cost for as many years of gas purchases you hedged. In the above example, that would be a decade of paying $2.00 more per gallon for your gas.
Part #6: In conclusion: Be careful and understand the risks:
While none of these strategies are perfect hedges, they do provide the opportunity for the investor to at least partially offset the costs of inflation, and take advantage of those rare crisis situations like 2008 that provide outstanding opportunities to lock in abnormally low prices. While I may have been wrong in the short term about the 10-Year Treasury having a bottom at 2.25%, I doubt that it will stay below that rate forever. 10 years from now I would imagine a 2.25% mortgage will only be a distant memory, and the subject of fiction novels. The key to any of these strategies is to understand the risks and objectives of your strategy, and execute it in a manner that minimizes the costs associated with placing and managing the hedge.
Disclosure: I am long TBT.
Additional disclosure: I manage an account that also holds TBF.