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Hedging programs are used by individuals and companies who want protection against adverse price moves which would affect the cash commodities in which they deal.
The Short Hedge
In a short hedging program, futures are sold. This strategy is used by traders who either own the underlying commodity or are in some way subject to losses if its price declines.
The Long Hedge
Suppose the miller knows in July that in September he will buy 10,000 bushels of wheat from a grain elevator operator for grinding into flour. He worries that wheat prices will rise in the meantime because he has already guaranteed a price at which to sell flour to a baker in October.
Because he does not have the wheat now, he is considered to be "short the actuals" or "short the cash market." Therefore, to hedge this risk in the futures market, he can buy two wheat futures contracts (each represents 5.000 bushels). In September the cash price of wheat rises, the value of his futures contracts will rise too. The profit on the futures "leg" of his hedge will be earned by selling the futures at a higher price than he paid when he initiated the position, and will offset the extra money he must pay the grain elevator operator for the wheat.
The Relationship Between the Hedger and the Speculator
Unlike the hedger, the speculator usually has no contact with the underlying commodity; he has no natural long or short position as in the case of the hedger. He is in the market to make profits by buying low and selling high. Speculators are very important to a market. They make it more liquid and often take the opposite side of hedgers' trades. In this way, they act as a type of insurance underwriter by bearing the risk which hedgers seek to avoid.
Much of the non-hedging activity in the futures markets involves spread trades (also called straddles). These strategies generally carry less risk than outright long or short positions; hence, they usually have lower margin requirements. Spreads involve the simultaneous buying and selling of futures contracts with different characteristics.
Compared to speculators, traders who put on spreads tend to make limited profits; they also suffer milder losses and likely enjoy a better night's sleep.