Hedging in the futures market is a two-step process. Depending upon the hedger's cash market situation, he will either buy or sell futures as his first position. For instance, if he is going to buy a commodity in the cash market at a later time, his first step is to buy futures contracts. Or if he is going to sell a cash commodity at a later time, his first step in the hedging process is to sell futures contracts.
The second step in the process occurs when the cash market transaction takes place. At this time the futures position is no longer needed for price protection and should therefore be offset (closed out). If the hedger was initially long (long hedge), he would offset his position by selling the contract back. If he was initially short (short hedge), he would buy back the futures contract. Both the opening and closing positions must be for the same commodity, number of contracts, and delivery month.
Example: Assume in June a farmer expects to harvest at least 10,000 bushels of soybeans during September. By hedging, he can lock in a price for his soybeans in June and protect himself against the possibility of falling prices.
At the time, the cash price for new-crop soybeans is $6 and the price of November bean futures is $6.25. The delivery month of November marks the harvest of new-crop soybeans.
The farmer short hedges his crop by selling two November 5,000 bushel soybean futures contracts at $6.25. (Typically, farmers do not hedge 100 percent of their expected production, as the exact number of bushels produced is unknown until harvest. In this scenario, the producer expects to produce more than 10,000 bushels of soybeans.)
By the beginning of September, cash and futures prices have fallen. When the farmer sells his cash beans to the local elevator for $5.72 a bushel, he lifts his hedge by purchasing November soybean futures at $5.95. The 30-cent gain in the futures market offsets the lower price he receives for his soybeans to the cash market.
|June||Price for||Sells 2 November|
|new-crop soybeans at||soybean contracts|
|September||Sells 10,000 bushels||Buys 2 November|
|soybeans at||soybean contracts at|
|Result||Cash sale price $ 5.72/bushel|
|Futures gain + .30/bushel|
|Net selling price$ 6.02/bushel|
Had the farmer not hedged, he only would have received $5.72 a bushel for his soybeans - 30 cents lower than the net selling price he received. Click here to see self-study guide to hedging grains (pdf). Or to see contract specifications, click here to see Grain and Oilseed Futures and Options (pdf).
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. TRADING FUTURES AND OPTIONS INVOLVES SUBSTANTIAL RISK OF LOSS AND IS NOT SUITABLE FOR ALL INVESTORS.