The cash flow implications of hedging commodity positions with futures

By Saurabh Goyal, Founder & CEO of Phlo Systems. Published 23 April 2026.

Hedging your commodity positions with futures reduces P&L variance. It also creates cash flow volatility that can be larger than the P&L volatility it removes. Many SME commodity traders discover this only after their first margin call.

This article explains how futures hedging affects cash, what the magnitude looks like in practice, and how to think about whether the trade-off is right for your firm.

The fundamental trade-off

A physical commodity trader without hedges has P&L risk: when copper drops £500/t and you're long 1,000 tonnes of physical, you've lost £500K on paper. That's painful, but it's a balance-sheet event, not a cash event. You don't have to pay anyone today.

The same trader with a futures short hedge of 1,000 tonnes, when copper drops £500/t, has £0 P&L (the physical loss and the futures gain offset) but has just received £500K in variation margin into their futures account. Cash positive.

So far so good. But the same trader the next day, when copper rises £500/t, has £0 P&L again but has to pay £500K in variation margin. Cash negative — and the variation margin is due tomorrow.

This is the fundamental trade-off: hedging trades P&L volatility for cash volatility. In stable markets the cash volatility nets to roughly zero. In trending markets it accumulates and can become large.

The mechanics

Futures contracts are marked to market daily. Every tick the futures price moves against your hedge, you owe variation margin. Every tick it moves in your favour, you receive variation margin.

There's also initial margin — a deposit you put down when you open the position. This is roughly 5–15% of the notional value of the contract, depending on the commodity, exchange, and clearer. For 1,000 tonnes of copper at £8,400/t, initial margin is roughly £400K–£1.2M tied up before the position has moved at all.

Variation margin and initial margin together create three cash flow patterns that don't exist in unhedged trading:

1. Working capital lockup. Initial margin sits in your futures account doing nothing. It's your cash but you can't use it.
2. Daily cash swings. Variation margin moves daily. A £100M notional hedge book with 2% daily price volatility can swing £2M per day in cash.
3. Margin call risk. If price moves further than the working margin in your account, you get a margin call — typically 24-hour notice to top up. Failure to meet a margin call results in forced liquidation at unfavourable prices.

A worked example

A UK aluminium trader holds 5,000 tonnes of physical at an average cost of £2,200/t. They hedge by shorting 5,000 tonnes of LME aluminium futures at £2,200/t.

• Notional hedge: £11M
• Initial margin (~10%): £1.1M
• Daily price volatility (2% normal, 5% stressed): £220K–£550K daily variation margin

Aluminium rallies 10% over two weeks to £2,420/t. The trader's physical position has gained £1.1M unrealised. The trader's futures short has lost £1.1M, paid out as variation margin daily.

• Net P&L over two weeks: £0
• Cash impact: £1.1M out the door (variation margin) plus £110K of additional initial margin (because the contract value rose), plus the £1.1M that was already locked up

If the trader's working capital line couldn't support that £2.3M of effective cash drawdown, the hedge becomes a forced unwind — at exactly the wrong moment. Suddenly they're unhedged, the price rallies more, and they take a loss on both legs.

This is the textbook way that hedging "blew up" the firm. The hedge was directionally correct. The cash management was not.

How to think about whether to hedge

Three questions:

1. What is your working capital headroom? Hedging requires a working capital buffer roughly equal to (initial margin + 1.5× the worst-case 5-day variation margin). If you don't have that buffer or a committed credit line for it, your hedge has cash flow risk that can exceed its P&L benefit.

2. What is your hedge ratio? Many SME traders run partial hedges (e.g. 30–60% of physical inventory) precisely to limit cash exposure. A 30% hedge ratio reduces P&L variance by 30%, requires 30% of the cash buffer of a full hedge, and accepts that 70% of the position remains exposed to price moves.

3. What is your time horizon? Hedging a 1-month inventory position is a different cash profile from hedging a 12-month tolling contract. Long-dated hedges accumulate variation margin across the full term. Short-dated hedges don't.

The right way to size the cash buffer

Practical formula for a UK SME trader:

Required cash buffer = (Initial margin) + (Notional × σ × √5 × 2.33)

Where σ is the daily price volatility of the commodity (typically 1–4%), √5 scales to a 5-day horizon, and 2.33 covers a 99% confidence interval.

For our aluminium example: £1.1M initial + (£11M × 0.025 × 2.236 × 2.33) = £1.1M + £1.43M = £2.53M required buffer.

If your cash plus committed undrawn credit is less than that number, partial hedging is the safer option until your cash position grows.

Common mistakes

Hedging without a forecast. Variation margin is a daily cash event. Without a 13-week cash forecast that explicitly models margin calls under stressed scenarios, you don't know whether your hedge is fundable.

Hedging illiquid markets. Forward contracts in less-liquid commodities (e.g., specialty metals) sometimes look attractive but unwinding under stress is impossible. Stay with exchange-traded futures unless you have unbreakable cash.

Treating the hedge account as an emergency cash source. Variation margin received during favourable moves is real cash, but pulling it out reduces your buffer for the next adverse move. Keep it in the hedge account or in a clearly identified margin reserve.

Not coordinating treasury with trading. The Head of Trading decides the hedge size; the CFO discovers the cash impact when the call comes. By then it's too late. The decision needs to be joint, with treasury authority over hedge sizing.

Frequently Asked Questions

Should we hedge at all if it creates this cash risk?

Hedging makes sense when (a) you have the working capital to support variation margin under stress, and (b) the P&L volatility you're hedging against is large enough to threaten the firm's solvency. If neither condition is met, partial hedging or no hedging may be the right answer.

What about options instead of futures?

Buying options (e.g. a put to protect a long physical position) caps your downside without margin call risk — you pay the premium upfront and that's the maximum cost. The trade-off is that the premium is real and immediate, whereas futures hedging is cash-neutral in expectation. Options hedging has lower cash risk but higher P&L drag.

Does our bank give us credit against the hedge?

Some commodity finance banks (BNP Paribas, Société Générale, Rabobank, ING) extend hedge-aware financing — they treat your hedged inventory as lower-risk collateral and give you better margin treatment. This eases the cash buffer requirement substantially.

How does this work for cleared OTC vs exchange-traded?

Mechanically similar — OTC cleared trades on CME ClearPort or LCH have the same daily margining as exchange futures. Bilateral OTC (uncleared) has variation margin under ISDA CSAs but the mechanics are negotiated. For SMEs the simplification of exchange-traded is usually worth the basis risk.

How does an integrated CM platform help with this?

It produces a 13-week cash forecast that explicitly models margin calls on your hedge book under multiple price scenarios, alerts when margin requirements approach your committed credit headroom, and ties hedge sizing directly to working capital availability rather than treating them as separate decisions.

How Phlo Systems helps

opsPhlo treats hedging and treasury as one decision, not two. The platform models initial margin and variation margin on every hedge in real time, projects the cash impact under stress scenarios, and ties hedge sizing to your committed working capital headroom. The CFO and the trading desk see the same picture.

finPhlo extends this by managing the underlying trade finance — facility utilisation, multi-bank treasury, and cash forecasting — so that your hedging decisions are made against the real available liquidity, not against an estimate.

For SME traders who hedge or are considering it, this prevents the most common failure mode: directionally correct hedges that become forced unwinds because the cash wasn't there.

If you'd like to see how your current hedge book looks under a 5% adverse move, request a stress test demo at opsphlo.com or explore finPhlo for treasury management.

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Related reading:

• Cash Flow at Risk (CFAR) for commodity trading firms: a practical guide
• The risk metrics that actually matter for SME commodity traders who don't hedge
• Why SME commodity traders deserve an integrated ERP + CTRM + Treasury system

Saurabh Goyal is the Founder & CEO of Phlo Systems. He has built hedge-aware treasury infrastructure for trading firms across base metals, soft commodities, and energy.