Hedging with Futures
Hedging Logic
A hedge uses futures to offset price risk in a cash position. A producer or holder of inventory uses a short hedge to protect against falling prices. A consumer or user of a commodity uses a long hedge to protect against rising prices. Hedging transfers price risk but does not guarantee a profit; it fixes or stabilizes the effective price.
Hedges are exposed to basis risk, because cash and futures prices do not move perfectly together. For a short hedge, the effective selling price is approximately the initial futures price plus the basis at the time the cash commodity is sold. A strengthening basis helps the short hedger; a weakening basis hurts. Cross hedges use a related but different contract; hedge ratio adjusts for quantity and price sensitivity.
Traps
Questions often imply a hedge eliminates all risk. It does not: basis risk, margin calls, and production or demand risk remain. Do not confuse a short hedge with a short speculation; the hedger owns or expects the cash commodity. Also remember that hedgers may receive different margin treatment, but they are still marked to market.
Worked Example
A farmer hedges with a short futures sale at 450 cents. Expected basis is −20 cents, so the expected cash price is 430 cents. At sale, futures are 460 and basis is −10 cents; cash received is 450 cents. Effective price = initial futures 450 + final basis (−10) = 440 cents, better than the expected 430 cents because basis strengthened.