The concept of hedging is one of the core reasons why commodity futures exist in the first place. As the price of their harvest was dependent on supply, demand and season, farmers wanted to secure prices for their crops way before they delivered them. Thus, they purchased futures contracts with the commodities exchange. At the point of contract maturity, these traders will then deliver their products at a price stated in the contracts. With this, farmers are able to anticipate prices for their crops especially in a fluctuating market.

 

While the hedging concept was believed to have started in 17^th century Japan where farmers sold tickets for rice crops stored in their warehouses, the futures market in the United States first opened in the mid 19^th century. This was when the Chicago Board of Trade opened in 1848, followed by the New York Coffee, Cotton and Produce exchange. Right now, there are ten commodity futures exchange in the United States, with many more exchanges located in various countries around the world.

 

In hedging, prices for the cash market and the futures market tend to offset one another. This means that a loss in one market will be offset by a profit in another market. This way, buyers and sellers are protected in cases of price hikes or price drops. A farmer or a producer who is looking into selling a commodity at a future date may sell a futures contract now, also known as shorting the market. Then, as the contract nears the mature date, he will buy the contract to offset his short hedging earlier. At this point, profits and losses between the sale and purchase prices will be offset by the price he sells his commodity for in the cash market. This way, the producer will be able to obtain a price that is approximately what he had anticipated for a few months earlier before his commodity was ready for sale.

 

There are three situations where hedging may occur – Storage hedging, Production hedging and Hedging expected purchases. In storage hedging, producers will short on futures contracts to protect themselves from declining prices, while a commodity is being harvested. Then, they will buy the contracts at the point when their commodity is sold in the cash market. This way, gains in the futures market will offset losses in the cash market.

 

With Production hedging, contracts are sold at the point when commodities are being grown, to be bought back at the point when these commodities are ready to be sold. However, as the volume of production may vary while a crop is being grown, it is advisable for producers to purchase contracts for not more than two thirds of their expected yield.

 

Finally, Hedging expected purchases occur when raw material or commodities need to be purchased at a future time. In order to avoid purchasing at a higher price, buyers purchase long futures contracts to be sold when these raw material are purchased in the cash market. With this, profits from the futures market will offset the lower prices in the cash market.