Hedging is a trading operation that allows a person to transform a less acceptable risk into a more acceptable one. This is done by engaging in an offsetting operation in the same commodity under roughly the same terms as the original transaction that created the risk. Futures purchases or sales that are equal and opposite to a physical sale or physical transaction are made with the expectation that any loss on the physical transaction will be largely or fully compensated by a gain on the offsetting futures operation. In other words, the primary purpose of futures markets is to provide an efficient and effective mechanism for managing price risk. Individuals and businesses seek to protect themselves against adverse price changes, which they do by buying or selling futures contracts. This practice is called hedging.Hedging serves all levels of the marketing chain: those who are exposed to the risk of falling prices (sellers), rising prices (buyers), or both (buyers/sellers).The principle of hedging is quite basic, but one critical premise applies: hedging is based on the idea that prices of the physical commodity and the futures contracts generally move closely together. But it should be understood from the outset that some risk (the differential risk) cannot be hedged in the futures market.As buyers and sellers, coffee exporters or traders face two potential loss risks: one before purchasing physical coffee and the other following a purchase of physical coffee.
Before physical (green) coffee purchase - risk of rising price. If the exporter or trader has a commitment to supply physical coffee at some future date and has no coffee stocks, i.e. they are 'short' physical coffee, then they will be sensitive to the development of the buying price.After purchase of physical coffee - risk of falling price.The exporter or trader, who now is 'long' unsold physical coffee, will be sensitive to the development of the selling price.
Long coffee = short futures. Someone who is 'long' physical coffee will enter into an offsetting transaction by selling futures contracts (going 'short' futures) in proportion to the physical contracts at risk.Short coffee = long futures. Conversely, that someone will seek to minimize their risk when they are 'short' physical coffee by buying futures contracts (going 'long' futures) to keep their book or position in balance.The offsetting transactions are liquidated at the same time that the physical deals are completed, i.e. when the trader sells the physical coffee they have previously bought, they will at the same time buy the futures contracts needed to wash out (offset) their original sale of futures. On the other hand, when the trader buys the physical coffee they have originally sold short, they will simultaneously sell and wash out the futures contracts they had purchased to offset that short position in physicals.Participants at other levels of the coffee industry, such as producers, are primarily concerned with one side of the market. Obviously producers are very vulnerable to falling cash prices and therefore will be concerned with protecting a selling price.