Hedging

A practice that reduces the risk of holding one asset, by taking a position in a related asset. Hedging is based on the principle that cash market prices and futures market prices tend to move up and down together. This movement is not necessarily identical, but it usually is close enough that it is possible to lessen the risk of a loss in the cash market by taking an opposite position in the futures market.

A hedge is the buying or selling of a futures contract for protection against the possibility of a price change in the physical commodity that the business is planning to buy or sell. There are two types of hedges: a long hedge and a short hedge.

Short Hedge

A short hedge is the selling of a futures contract to protect the sale price of a commodity the business is planning to sell.

Long Hedge

A long hedge is the buying of a futures contract to protect the purchase price of a commodity the business is planning to buy. Most hedges are liquidated or offset prior to delivery or expiration. The long hedger can offset their futures contract by subsequently selling a contract with the same delivery month.

While most contracts entered into do not result in delivery, the threat of delivery still tends to serve the purpose of keeping the prices of futures contracts and their underlying cash market in reasonable alignment with one another. The cash market is where physical commodities are bought and sold.