Hedging: short and long hedges
Futures markets exist, first of all, so that businesses can manage price risk. CME calls hedging “the very foundation” of the agricultural futures industry. In hedging, price risk passes from people who want less of it to people (speculators) who are willing to carry it in hope of a profit.
The core idea
The CFTC glossary describes a hedger as someone who takes futures positions opposite to positions held in the cash market, to reduce the risk of loss from an adverse price change. A hedger may also buy or sell futures as a temporary substitute for a cash purchase or sale that will happen later.
Why does this work? CME explains that cash and futures prices are highly correlated: they tend to rise and fall together because the same economic forces drive them. And as the delivery month approaches, cash and futures prices come together (converge). So if you are long in the cash market and short in futures, a loss on one side tends to be balanced by a gain on the other.
Your cash position comes first
To pick a hedge, first name your position in the cash market:
- Long cash: you own the commodity, or are growing or producing it. A farmer with a crop in the field is long cash.
- Short cash: you will need to buy the commodity later. A feed manufacturer that must buy grain next quarter is short cash.
Then take the opposite position in futures. CME’s rule of thumb: if your future action is selling in the cash market, the hedge today is selling futures. If your future action is buying in the cash market, the hedge today is buying futures.
The short hedge (selling hedge)
The CFTC defines a selling hedge (or short hedge) as selling futures to protect against possible decreased prices.
Who uses it: those who need protection against falling prices. CME lists farmers, merchandisers, and grain elevators. The NFA Series 3 study outline lists the typical short hedgers as farmers, producers, and holders of inventory.
How it works: sell futures now; buy them back later when you sell the physical commodity.
Made-up example (round numbers for teaching, not market data). In spring a wheat farmer expects to sell grain in summer. Futures are $6.00 per bushel and the local cash price usually runs 30 cents under futures, so the farmer aims for about $5.70. The farmer sells futures at $6.00.
| Summer outcome | Cash sale | Futures result | Net price |
|---|---|---|---|
| Prices fall: cash $5.20, futures $5.50 | $5.20 | Sold $6.00, bought back $5.50: gain $0.50 | $5.70 |
| Prices rise: cash $6.20, futures $6.50 | $6.20 | Sold $6.00, bought back $6.50: loss $0.50 | $5.70 |
Either way the farmer nets $5.70. The hedge protected against the drop, but it also gave away the extra money from the rise. That trade off is the price of certainty.
The long hedge (buying hedge)
The CFTC defines a buying hedge (or long hedge) as buying futures to protect against possible increases in the cost of commodities.
Who uses it: those who need protection against rising prices. CME lists food processors, feed manufacturers, and importers. The NFA Series 3 study outline lists the typical long hedgers as processors, manufacturers, and exporters.
How it works: buy futures now; sell them later when you buy the physical commodity.
Made-up example. A feed mill must buy corn in three months. Futures are $4.00 per bushel and its local cash price usually runs 10 cents over futures, so it aims for about $4.10. It buys futures at $4.00. Three months later prices have risen: cash is $4.60 and futures are $4.50.
- Cash purchase: pays $4.60.
- Futures: bought $4.00, sold $4.50: gain $0.50.
- Net cost: $4.60 minus $0.50 = $4.10.
Had prices fallen instead (with the basis still 10 cents over), the mill would have paid less in cash but lost the same amount on futures, again netting $4.10.
Unhedged means exposed
A business that owns grain and does not hedge carries the full price risk. If prices fall before it sells, it takes the whole loss. That is not wrong, but it is a choice to keep price risk rather than transfer it.
What a hedge does not fix
In both examples the gap between cash and futures (the basis) stayed exactly where it was expected. In real markets it moves. CME’s summary is that hedgers reduce price risk “by assuming basis risk,” and that basis risk is typically much lower than price risk. The next lesson shows how a change in basis changes the hedger’s final price.
Hedgers can also use options. CME notes that a buyer can purchase a call to set a ceiling price and a seller can purchase a put to set a floor price, while keeping the chance to benefit if prices move their way. The options lessons later in this track cover how that works.
Key ideas
- Hedging = taking a futures position opposite your cash position, so cash losses are balanced by futures gains.
- It works because cash and futures prices move together and converge near delivery.
- Short (selling) hedge: sell futures; used by owners and producers who fear falling prices (farmers, elevators, merchandisers).
- Long (buying) hedge: buy futures; used by future buyers who fear rising prices (processors, manufacturers, importers, exporters).
- Rule of thumb: future cash sale means sell futures now; future cash purchase means buy futures now.
- A hedge locks in a price level, giving up favorable moves, and it trades price risk for basis risk.