The most important role of the early futures markets was to hedge unsold stocks. During the peak marketing season of a commodity, traders often bought enough supplies to meet both their current orders and future demand until new supplies became available. Those with heavy stocks of an unsold crop could face serious losses in the event of a fall in prices. Similarly, those who chose to save on storage costs by relying on purchasing stocks at a later date, and made forward sales based on current cash prices, would incur losses if prices rose sharply. Hedging therefore focuses on transferring the risk of drastic price changes to other parties in the market.Hedging is sometimes also described as a form of insurance but this is not entirely correct. Buying or selling futures contracts involves buying or selling at a specific price, thereby committing to a specific price. In contrast, the strike price in an option is used to establish a price floor or ceiling to provide some level of price protection or insurance. As with insurance, the premium paid for the option determines the level of protection purchased. See 09.03 for more on options.The traditional view of hedging as risk transferral has evolved into the more dynamic concept of risk management. Under this concept, hedging is viewed as a tool for decisions on buying and selling. The basic principle of hedging consists of buying or selling a futures contract that is equal and opposite to the physical trading commitment entered into outside the exchange. Any loss on the physical or cash market resulting from a disadvantageous movement of prices would be offset by a profit on the exchange transactions.
Cash market losses = futures market gains
Cash market gains = futures market losses
In order to effectively use futures markets for hedging it is important to understand what they can and cannot do.
The main motivations for hedging stem from the need to reduce or eliminate the price risk that results from being long in actuals (carrying unsold stocks of physical coffee) or short in actuals (selling forward in the physical market without already owning the physical coffee). Although dealers may be short or long in the physical commodity, they may be square overall if they also have some compensating transaction so that, whether the whole market goes up or down, the advantage or disadvantage is neutralized. The compensating, or hedge, transaction may be another physical deal or a futures deal. In other words, whatever physical transaction one may be planning or committed to carrying out can be countered by an equal and opposite move in the futures market. The hedge can also come from a fixed price, forward contract arrangement in the physical market, or a combined physical and futures hedging plan. The idea is to protect a profit margin or, at the very least (in the case of a producer) to cover all or part of the cost of production.A long holder (that is, one likely to hold stocks of a commodity, such as a coffee producer or processor) enters the futures market in order to transfer risk in the physical market to another party. In this sense they have 'bought a price' by locking into a futures contract to protect against declining cash prices. Conversely, they have forfeited the chance of making a profit if cash prices rise. Traders who do not hedge can enjoy extra profit if prices rise, but are unprotected if prices drop. Many traders finance their operations with substantial short-term credit facilities. It is not at all unusual for bankers to insist that traders offset their trading risks through hedging, thereby limiting the consequences of unexpected disturbances in the market.The producer's position differs from that of other players in the coffee market in that their buying price is in fact their production cost. This cost may not necessarily bear any relation to the current prices in the physical or futures markets. Thus, producers can hedge the risk that sales prices will be lower in future months but cannot offset their cost price if current market prices do not cover production costs.Operators who are not constrained by production costs will always have an opportunity to offset their purchase price in physicals with a selling hedge and vice versa, regardless of market levels. A trader in physical coffee engages in hedging to protect a profit margin, rather than an absolute price. The trader needs only to achieve a positive difference between their buying and selling price.