The common goal of many users of the wheat market is to minimize risks associated with exposure to wheat prices, but that’s not usually the first thing that comes to mind. There are several typical connotations that arise at the mention of futures markets; including visions of high risk tolerant individuals wheeling and dealing on exchange floors in a flurry of hand signals and shouts. These are the images that seem to stick. Even though the looser capitalists do make and lose fortunes, they only make up a very small portion of the people who use the wheat futures markets. In fact, the general intentions of many market participants are the exact opposite. I’m referring to hedgers of wheat prices. They use futures markets because wheat is an input or output of their business. Without the wheat futures, these commercial interests would have a hard time dealing with fluctuations in wheat prices. There is any number of different types of hedges, but there are two very common ones used by a number of different commercial interests.
The whole notion of commercial hedging is based on the idea that cash and futures wheat prices tend to move together. Imagine for a second that you own a flour milling company. Your major input is wheat; therefore your most significant production cost is variable depending on the movements of wheat prices. That’s if you don’t hedge your costs. At this point, prior to any hedging, you have a short wheat position on. Say you’re going to need to secure 50,000 bushels of wheat at a future date. If prices go down, great; if prices increase, you’re costs are going to be higher. What you can do is buy ten wheat futures (50k bushels) now. When the time comes to actually buy your input wheat, the market may have moved. If it went up, your losses incurred by the higher price of wheat will be offset by gains on your futures contracts, which you now sell back. If the opposite occurs, than your gains and losses are switched. Essentially, by hedging with the futures market, you can secure the current cash market price at a future delivery date. Farmers would do the exact opposite because they are considered to have a net long position when their crops are in the ground. They benefit when wheat prices rise, and are hurt when prices drop. This is called a long hedge and it’s conducted in the exact opposite manor of the short hedge.
The futures market plays a very important role for commercial users. Business operations involving wheat as either an input or an output would be much more exposed to market risks if they weren’t able to hedge their production or consumptions.
Trading in futures and options involves a substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future results.
