Agricultural Futures for Commodities Buyers

The principles of hedging with futures are quite straightforward. The idea is that when a trader buys a futures contract (the futures terminology is to ‘open a long position’), he must offset it later by ‘closing the long position’. The second futures transaction takes place when the trader takes delivery of the crop, i.e. the cash market transaction occurs. The futures contract is closed out as the price protection is no longer needed after the physical delivery is made.

For example, let us assume that it is now March, and you have a contract to take a shipment of corn in the month of June¹. Corn harvests this season are expected to be abundant, but unexpected geopolitical events might cause corn prices to spike higher when the corn is shipped in June. You can lock in the price for your corn now to protect your profit margin against a potential rise in corn prices.

Let us say that it is now March 1, 2018. The price for the CBOT July corn future contract is $3.93 per bushel at this time.  You are comfortable with this price level as an importer, and you buy the CBOT July corn futures now, to lock in the $3.93 price you will eventually pay for your physical corn. In futures terminology, you have taken a ‘long hedge’ position.

It is now June 14, and the tariff war did not have an adverse effect on the corn market. Both the cash price and July futures price of corn fell to $3.63, at the time you made payment to the seller.  You therefore accepted the shipment of your corn at $3.63. You originally expected to pay $3.93, so you have made a gain of $0.30 from the physical transaction. 

You now concurrently close out your long corn futures position by selling the July futures contract at the prevailing price of $3.63.  As you had opened your long futures position at $3.93, you made a $0.30 loss ($3.63 – $3.93) in the futures market. This loss in the futures transaction offsets the gain in the cash market, and the net result is that you have achieved his original target of buying corn at $3.93.

Of course, had the importer not engaged in a hedging strategy, he might have received an additional $0.30 per bushel profit on the purchase. However, he would also have been exposed to the risk of making a loss on his purchases had corn prices spiked up during that same period.

This is the essence of hedging. The key objective is to make an importer’s profit margin more consistent by locking in his purchase price, and he is prepared to forego the potential gain from unexpected favorable price movements in order to reduce his overall price risk.

1. CBOT Corn futures contracts are listed for the March, May, July, September and December contract months. We had assumed that the shipment is in June, so that the July futures contract, which expires around mid-July, can be used to fully hedge the exposure.