What Is Hedging?

Two legs pointing opposite ways

Holding the physical asset makes you long, so you fear a fall. Sell an equal amount of futures to set up a short leg: when the price falls, the physical loses and the futures gain, and the two cancel out. That's a hedge.

The goal of hedging is certainty

Hedging won't make you more money: when prices rise, the futures eat the extra gain on the wheat. What you get is certainty of income, so the farmer can plant, borrow and sign contracts as planned with peace of mind.

You choose how much to hedge

You don't have to hedge everything. Selling just 1 futures contract is a half hedge: for every $1 the price falls, you lose only half as much. The higher the hedge ratio, the more certain the outcome and the less room left for gains: a trade-off between certainty and opportunity.

Key takeaways

• Hedging = taking a position opposite to your existing exposure, so the gains and losses on the two sides offset each other.
• Once fully hedged, price moves up or down don't change your total value, but you also give up the benefit of the price moving your way.
• The goal of hedging is to reduce uncertainty, not to make more money.

Try it yourself

You can do these exercises in this lesson's interactive simulation:

1. Click "Example: full hedge + price falls": when wheat falls to $4.80, how much does the physical lose? How much do the futures make? Did the total value change?
2. Keep "Price falls," switch to 0 contracts and play again: how much less income on harvest day?
3. Switch to "Price rises" with a full hedge: where did the extra gain on the wheat go? Does that count as a loss?
4. Pick 1 contract (a half hedge) and look at the chart below: why is the slope of the green total line exactly half the original?

Quiz and explanations

1. A farmer holds 10,000 bushels of wheat and worries prices will fall before the harvest. What should they do?

Answer: Sell wheat futures.The physical wheat is a long exposure, so offset it with a short futures position.

2. After fully hedging, wheat prices jump 20%. Overall, the farmer…

Answer: Roughly breaks even: the gain on the wheat is lost on the futures.The hedge locked in the value, and the upside was given away along with it.

3. The farmer has 10,000 bushels but sells only 1 futures contract (5,000 bushels each). Wheat falls from $6 to $4.80. What's the combined result of the wheat + futures?

Answer: −$6,000.The wheat loses 1.2 × 10,000 = $12,000 and the short futures make 1.2 × 5,000 = $6,000, for −$6,000 in total. Hedge half, and only half the risk remains.

Terms in this lesson

• futures (Futures): Standardized exchange-traded contracts to buy or sell an asset on a future date at a price fixed today.
• hedge (Hedge): An opposite trade that offsets the risk of an existing exposure.
• hedge ratio (Hedge Ratio): The size of the hedge relative to the original exposure; 1 means a full hedge, 0.5 means hedging half.
• long (Long): Buy first and sell later, betting the price will rise.
• short (Short): Borrow and sell first, then buy back to return it, betting the price will fall.