Hedging is the act of investing in a financial instrument for the purpose of minimizing risk in a different investment. Many producers and consumers of commodities use the Futures Market for this purpose.

Lets assume that farmer Joe who grows wheat wants to sell 10,000 bushels for December delivery, and that it is now July.

Joe checks the futures market today, and finds that Dec wheat is now at $3.50 per bushel, and Joe thinks this is a fair price.

Joe takes out a futures contract to sell 10,000 bushels on Dec 15th.

The summer passes, and Joe harvests his wheat. By December 14, wheat is selling for only $3.00 per bushel, .50 below what Joe wanted.

Joe then buys a futures contract for Dec wheat at the going price of $3.00 which cancels his contract to sell with a net profit of $0.50 per bushel, and then sells his physical wheat for $3.00 a bushel to the local grain elevator.

So Joe got $3.00 a bushel for his grain, plus he got $0.50 a bushel for his futures trading profits for a net price of $3.50 per bushel of wheat.

The Futures trades locked in the price of his physical wheat although no actual commodity was traded in the Futures market. The person who held the Futures contract which canceled out Joe’s Futures probably lost money on the deal. So speculators perform a service for Joe by assuming his risk as a grower.

Now, take the same scenario but lets assume the price of wheat went up to $4.00. On Dec 14th Joe must close his Futures position by buying an offsetting contract at $4.00 per bushel. He loses $0.50 per bushel on his Futures trade, but he got $4.00 for his physical wheat which netted him $3.50 per bushel.

Let’s look at a wheat consumer, Sal’s Bakery, who depends on a supply of wheat to make flour for his bakery.

Sal knows he will need to buy wheat in December to make flour for his bakery. Sal sees that the Futures price of wheat for December delivery is $3.50, and is willing to pay $3.50 a bushel for wheat in Dec, so Sal buys a future contract to purchase 10,000 bushels on Dec 15th.

On Dec 14th, physical wheat is selling for $4.00 per bushel, so Sal sells a Futures contract to cancel his position in the Futures market for $4.00 a bushel, and buys physical wheat at $4.00 a bushel.

Sal bought Futures wheat at $3.50, and sold Futures wheat at $4.00 for a net gain of $0.50 per bushel. Sal bought physical wheat for $4.00 but with his gain of $0.50 per bushel in the Futures trade, the real cost of his wheat was $3.50 per bushel. By trading Futures as a hedge, Sal locked in the price of his wheat at a price he thought was reasonable.

The big advantage of hedging is that it locks in a future price for suppliers and consumers of a commodity so that they can plan their business effectively. Of course they don’t have to hedge, and may wait for the opportune time to purchase their contracts.

Notice that this does not affect the spot price of the commodity, but may affect the price of the goods made from them (bread in Sal’s case). It may make bread cheaper or more expense with regard to the underlying commodity depending on Sal’s skill with trading Futures.

Futures prices are often higher than current spot prices because of inflation and storage costs. Suppliers know that the government will inflate the currency and they factor this in when contracting to sell a commodity at a future date. Likewise, if a supplier is storing a product, perhaps a seasonal commodity, for future delivery, they must also factor in the cost of storing their commodity.

This then is a brief explanation of how the Futures Market is used by both suppliers and consumers to hedge against unexpected fluctuations in the price of a product.