Futures Trading 101: What Does Hedging Mean?

So what exactly does it mean to hedge? First, there was Sonic the Hedgehog who repeatedly failed to defeat Dr. Robotnik. Then along came unregulated private funds like Long Term Capital Management which obviously didn't live up to it's name sake. Then there's futures trading, where a career can be made by taking the other side of speculator's trade. But how does it work? For all of you chimps out there, check out this infographic from Partnership For A Secure Financial Future on how hedging works...



HEDGE: an investment that is used in an attempt to reduce the risk of adverse price movements in an asset.



THE UNDERLYING
In this example, we use a farmer who investments their money into wheat to sell for a profit. However, there is risk involved such as drought, excess supply, flood, spoilage, etc. But it could just as easily be the same for purchasing a Dow 100 future in which the risk would be economic, fear, greed, geopolitical, or political. Just insert any investment that has risk and hedging can be used to minimize it.

BUYER-SELLER CONTRACT
The farmer determines their profit margin but is kept in-check by the baker. If priced too high, the baker will go to market for the lowest cost. If priced too low, the farmer will operate at a loss. It's probable that both will use a naive forecast and adjust accordingly once the wheat is harvested.

MARKET PRICING
The farmer and baker set a price for a future date irrespective of the market. The contract involves a particular commodity which details the quantity and quality of the asset and are settled in either cash or physical delivery. If there is excess demand and the market price is higher, the baker benefits. However, if there's excess supply then the farmer benefits instead of losing at market prices.

For more details, see the contract specifications here.


Stay tuned for next week's post where I share another infographic, What Is A Speculator?

Questions, comments, or concerns? Put it below.

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