Long Hedge Examples Using HRSW Futures
End users, such as millers, have commercial need for the physical Hard Red Spring Wheat (HRSW) product and are said to have a “short” cash position. This means they do not have the product but do have a future need for it. This circumstance means they are at the whim of the cash market between the time they determine their need and the time when they will buy the physical product in the cash market. If the cash price goes up, then their HRSW costs do too. Conversely, if the price goes down, so does their cost. At this time, end users are considered not “hedged” and exposed to price risk.
Hedging means to have simultaneous offsetting positions in both the cash and futures markets. The end user is short in the cash market and needs to “go long” or buy futures. Typically end users will buy in the first contract month which follows their intended typical cash market transaction date. They would use the futures market as a temporary substitute representing ownership of the appropriate quantity of HRSW needed for milling. At the time of the cash purchase the miller would sell back, or exit, the futures market position, which would offset the purchase of futures. A futures contract is a commitment to buy or sell a specific quantity and quality of a commodity at a time in the future. For this example, HRSW contract specifications will be utilized and the contract size is 5,000 bushels.
In this way, any increase in one market should be counterbalanced by an offsetting decrease in the other market. This would “lock-in” the purchase price. This assumes one’s local cash market moves the exact amount as the futures market. In reality, they may not. This difference between the local cash and the futures market is termed “basis”. Basis has a tendency to follow historical trends and would be taken into account when deciding on which marketing options to pursue. In locking in a price the hedger gives up the opportunity for upside gain.
Let us assume for simplicity cash and futures market prices are the same on June 1 and the miller has booked flour for August delivery. Cash prices for September cash and futures are at $7.88. The miller has determined at this cost, he can maintain the company’s profit margins and wants to lock-in the purchase price of $7.88. The miller is short the cash market and needs to go long the futures market by buying the September futures contract. These are simultaneous offsetting market positions.
In mid-August, the miller decides to purchase the physical wheat just as he would customarily do. The cash and futures markets are now at $8.15. To the miller’s detriment, their cash price has increased from $7.88 to $8.15, translating to a $0.27 higher purchase price than when they initiated their hedging strategy in June.
On the futures side of the strategy, the miller would sell back the futures contracts at a higher price than he paid. This yields a gain of $0.27, less transaction expenses. Because of the higher price, the miller’s cash outlay is counterbalanced by the beneficial gain from the futures hedge. The miller has locked-in a purchase price of $7.88 and protected the company from HRSW price increase, achieving their desired goal.