How Hedging Works in Commodities Markets

The commodity markets are made up primarily of speculators and hedgers. It is easy to understand what speculators are all about; they are taking on risk in the markets to make money. Hedgers are there for pretty much the opposite reason: to reduce their risk of losing money.

A hedger is an individual or company that is involved in a business related to a particular commodity. They are usually either a producer of the commodity or a company that regularly needs to purchase the commodity.

An Example With Soybeans

A farmer is one example of a hedger. Farmers grow crops—soybeans, in this example—and carry the risk that the price of their soybeans will decline by the time they're harvested. Farmers can hedge against that risk by selling soybean futures, which could lock in a price for their crops early in the growing season.

A soybean futures contract on the CME Group's Chicago Board of Trade exchange consists of 5,000 bushels of soybeans. If a farmer expected to produce 500,000 bushels of soybeans, they would sell 100 soybean futures contracts.

Let's assume the price of soybeans is currently $13 a bushel. If the farmer knows they can turn a profit at $10, it might be wise to lock in the $13 price by selling the futures contracts. In that way, the farmer could avoid the risk that the price of soybeans would fall below $10 when they're ready to be sold.

There is always the possibility that soybeans could move much higher by harvest time. Soybeans could move to $16 a bushel, and the farmer would miss out on that higher price if they sold the $13-a-bushel futures contracts.

Failing to Hedge

Most airlines are now diligent about using hedges to protect against soaring prices of jet fuel. But in 2008, major airlines posted big losses—and some filed for bankruptcy protection—after the price of fuel spiked.

Farmers sometimes don’t hedge until the last minute. Grain prices often move higher in June and July on weather threats. During this time, some farmers watch prices move higher and higher and get greedy. They wait too long to lock in the high prices before they fall. In essence, these hedgers turn into speculators.

Original Purpose of Exchanges

Commodity futures exchanges were originally created to enable producers and buyers of commodities to hedge against their long or short cash positions in commodities. Even though traders and other speculators represent the bulk of trading volume on futures exchanges, hedgers are their true reason for being.

While futures exchanges require hedgers to pay margin—upfront money to cover potential losses—just like they do for speculators, the margin levels are often lower for hedgers. That's because the exchanges view hedgers as less risky because they have a cash position in a commodity that offsets their futures position. A hedger must still apply for these special margin rates through the exchange and be approved after meeting certain criteria.