Why Hedging “Loses Money”: A Primer on Basis Risk

"We hedged and still lost money." This is the most common sentence we hear in diagnostics. In the vast majority of cases the loss has nothing to do with getting the market wrong. It comes down to one variable that gets ignored: the basis. Understanding basis is the key to understanding why hedging works — and why it fails.

A common misconception: hedging does not mean "making money on futures"

Many companies treat hedging as "earning again in the futures market". That belief has two consequences: the hedging desk gets measured on its futures account P&L, and any loss is taken as proof that hedging does not work.

The correct framing is this: hedging converts unmanageable absolute price risk into manageable basis risk. The physical and futures legs must be assessed together; the futures account on its own tells you nothing. If the physical side saves RMB 2 million while the futures account loses RMB 1.8 million, the hedge worked — it locked in RMB 0.2 million of net gain and removed a RMB 2 million swing.

What the basis actually is

The calculation is simple:

Basis = physical price − futures price

It measures how much more, or less, the physical is worth than the futures right now. That sounds like a trivial difference, but it carries three real costs:

• Time: physical delivery and contract month differ, involving storage, insurance and financing cost;
• Location: the gap between exchange delivery points and where the goods actually originate or are needed;
• Quality: futures reference a benchmark grade, while the physical carries a premium or discount.

The key insight: the basis is not random noise. It has real economic content, and therefore it has patterns.

Hedge effectiveness is determined by basis change, not price direction

This is the single most important table in the whole methodology. Remember one rule: a strengthening basis favours the seller; a weakening basis favours the buyer.

Take a buy hedge — a company worried about input prices rising buys futures first. If the basis strengthens, the physical rises faster than futures, the futures gain cannot fully cover the higher physical cost, and you get a partial loss. If the basis weakens, the futures gain exceeds the increase in physical cost, producing a partial gain. Note that this has nothing to do with whether futures prices themselves went up or down.

In practice, a mature hedging desk does not ask "how much did it move today" — it asks "where is the basis and which way is it trending".

Three things companies can do about basis risk

First, monitor the basis routinely

Build a basis ledger: record physical quotes and the corresponding futures price for each commodity and region, creating a time series. Once you have more than a year of data you can calculate historical percentiles — where today's basis sits against the past three years. This needs no sophisticated system; a well-structured spreadsheet and daily discipline will do.

Second, use pricing mechanisms to split the decision

Basis pricing separates "setting the basis" from "setting the futures price", letting each side price at a moment that suits them. The seller quotes a premium or discount to lock the relative price; the buyer chooses the futures price within an agreed window. Neither side bargains over absolute price — they read the market together.

Third, decide whether to move to basis trading

Once basis is managed reliably, a company can upgrade from hedging alone to basis trading with upstream and downstream counterparties. Each side plays to its strength — physical channels and futures execution — with one locking a fixed return and the other taking the market movement.

But sequence matters: basis trading extends hedging capability, it does not replace it. A company without its own basis monitoring and hedging discipline will amplify risk rather than reduce it.

Back to the original question: why does hedging "lose money"?

Putting it together, the answer is clear:

• if hedging lost money, first check whether the futures account was measured in isolation and the physical gain ignored;
• then check whether the basis moved adversely while nobody was monitoring it;
• then check whether the hedge ratio ran away beyond actual exposure, turning the hedge into speculation;
• and finally whether funding was insufficient, forcing a close-out at the worst price.

The first two are awareness problems; the last two are policy and funding problems. None of them is solved by better market forecasting — they are solved by structure. This is precisely where a systematic diagnostic earns its place: clarifying exposure, basis, ratio and funding in one pass turns hedge outcomes from luck into something explainable and repeatable.