Hedging

Hedging is using a futures or other derivative position to offset the risk of an adverse price move in a commodity a person already holds or plans to trade.

Hedging lets a business lock in a price today for a transaction it will complete later, transferring the risk of an adverse price move to someone else, usually a speculator. A coffee roaster that will need beans in six months can buy futures now; if the cash price rises, the futures gain offsets the higher cost of the physical beans it eventually buys. A wheat farmer does the reverse, selling futures against a crop still in the ground to protect against a harvest-time price drop.

A hedge is not free insurance. It removes the upside as well as the downside: the farmer who sells futures at a fixed price also misses out if prices later rally. What remains after a hedge is placed is basis risk, the gap between the futures price and the local cash price actually received. The mechanics of the futures leg are covered in spot vs futures.