Hedging on the
farm

The art of hedging

For a farmer, the primary goal of the futures market isn't to make a speculative profit; it’s to hedge. Hedging is a risk management strategy used to lock in a price for your crop months before you actually harvest it, protecting you against a sudden price drop.

Because you are producing a physical crop that you will eventually sell (meaning you are "long" on the physical commodity), you use the futures market to take the opposite position. You sell futures contracts (going "short") to lock in a price.

A simple example

The Setup:
In May, Farmer Joe expects to harvest 10,000 bushels of corn in October. He knows he needs $5.00 a bushel to turn a solid profit. The futures market is currently offering exactly that: $5.00.

‍The Action:
To lock in his profit and eliminate risk, Joe calls his broker and sells 10,000 bushels worth of futures contracts at $5.00.Fast forward to harvest time in October. Here are the two ways it can play out:

Scenario A:
‍The market crashes to $4.00. Joe sells his actual, physical corn at the local elevator for only $4.00. However, because the market dropped, he made a $1.00 per bushel profit on the futures contracts he sold back in May. His final take-home: $5.00 per bushel.

Scenario B: The market spikes to $6.00. Joe sells his actual corn at the elevator for a fantastic price of $6.00. However, because the market rose, he takes a $1.00 per bushel loss on his futures contracts.His final take-home: $5.00 per bushel.

The Takeaway: By hedging, Joe completely protects his farm from a devastating loss if prices crash. No matter what the global market does, Joe guarantees his farm makes the $5.00 per bushel he needs.