This guide details the placing of an output (short) hedge in the futures market for use in reducing the price risk associated with selling an output used in your business. For example, a cattle producer knows he/she will be selling a pen of cattle two months from now. The producer knows that by selling live cattle for over $62/cwt. he/she can insure a satisfactory profit. Currently, the local live cattle price is $64/cwt., and the producer believes that the fed price may drop during the next few months. By knowing the cost of production of these animals, the producer knows that the $64/cwt. will allow for a satisfactory profit. What can the producer do? The producer cannot sell the cattle now because the cattle are too light; however, the producer could enter the futures market and off-set any loss in value (decrease in price) with a gain in the futures market.

How do I Place a Hedge?

Placing a hedge can be a simple process. First, knowing your cost of production helps you know when to place a hedge. To place a hedge, you need to contact a broker with whom you place an order. Most large communities have a broker who will take your order for a set fee (as is common when placing any futures market order). The broker can be helpful in informing you on how to appropriately place and exit your hedging position. The broker has a stake, i.e., commission, in making sure your experience with hedging using futures is a good one. After you have placed the order with the broker, the broker will contact a brokerage house at the commodity exchange and relay the order. On the trading floor of the trading commission open out-call is used in matching market supply and demand forces. If you want to place a short hedge, there will always be either someone wanting to place a long hedge or a speculator willing to off-set your risk. This process is known as arbitrage and is discussed in more detail in an accompanying risk management guide in this series.

What Can Happen With the Short Futures Hedge?

Any of seven scenarios can arise between the cash and futures price. The only scenario not discussed below is that of the cash and futures prices not changing while the hedge is placed. In this scenario, the producer sells the output for the same price as when the hedge was placed. The costs of hedging would then simply be commissions. The other scenarios are discussed below. Because the cash and futures markets typically trend in the same direction over time the scenario of the cash and futures moving in opposite directions is not discussed.

A. Cash and Futures Price both Decreas

1. Cash Price Decreases Faster than the Futures Price (Basis Weakens)

Table 1 is used to describe the actions you might take as a hedger and the outcomes of those actions in placing an output hedge in which the cash price decreases by more than the futures price during the hedging period. In this scenario basis is said to weaken. Following from table 1, suppose today you could sell live cattle for $64/cwt. and the relevant futures contract is trading for $65/cwt. (basis is $1.00 under). Knowing that you will sell cattle at a later date and you want to protect against a price decrease, you take a short position in the futures market at this time. Over the next few months the local cash price decreases to $60/cwt. and the futures price decreases to $63/cwt. At this time you decide the cattle need to go to market. You sell cattle in the cash market for $60/cwt. and buy back your futures position for $63/cwt. Therefore, the revenue from selling cattle is $60/cwt. plus $2/cwt. gain from the futures position less any commission costs (a typical commission might be $30 for entry into the futures and $30 for exit, $60/round-turn or @ $0.15/cwt.). Instead of selling for $60/cwt. you sell for $61.85/cwt. The net price you receive is exactly equal to the original cash price plus the basis gain or loss less commission.

2. Futures Price Decreases Faster than the Cash Price (Basis Strengthens)

Table 2 is used to describe the actions you might take as a hedger and the outcomes of those actions in placing an output hedge in which the futures price decreases by more than the cash price during the hedging period. In this scenario basis is said to strengthen. Following from table 2, suppose today you could sell live cattle for $64/cwt. and the relevant futures contract is trading for $65/cwt. (basis is $1.00 under). Knowing that you will sell cattle at a later date and you want to protect against a price decrease, you take a short position in the futures market at this time. Over the next few months the local cash price decreases to $60/cwt. and the futures price decreases to $60/cwt. At this time you decide the cattle need to go to market. You sell cattle in the cash market for $60/cwt. and buy back your futures position for $60/cwt. Therefore, the revenue from selling cattle is $60/cwt. plus $5/cwt. gain from the futures position less any commission costs Instead of selling for $60/cwt. you sell for $64.85/cwt. Again the net price you receive is exactly equal to the original cash price plus the basis gain or loss less commission.

3. Futures Price Decreases at the same rate as the Cash Price

Under this scenario the price you pay is exactly equal to the price you would have paid earlier with the exception of commissions ($0.15/cwt). Following with the first two examples, there is no basis change here and the net price is simply equal to the original cash price less commission.

1. Cash Price Increases Faster than the Futures Price (Basis Weakens)

Table 3 is used to describe the actions you might take as a hedger would take and the outcomes of those actions in placing an output hedge in which the cash price increases by more than the futures price during the hedging period. In this scenario basis is said to strengthen. Following from table 3, suppose today you could sell live cattle for $64/cwt. and the relevant futures contract is trading for $65/cwt. (basis is $1.00 under). Knowing that you will sell cattle at a later date and you want to protect against a price decrease, you take a short position in the futures market at this time. Over the next few months the local cash price increases to $67/cwt. and the futures price increases to $66/cwt. At this time you decide the cattle need to go to market. You sell cattle in the cash market for $67/cwt. and buy back your futures position for $66/cwt. Therefore, the revenue from selling cattle is $67/cwt. less $1/cwt. lost from the futures position less any commission. Instead of selling for $67/cwt. you sell for $65.85/cwt.

2. Futures Price Increases Faster than the Cash Price (Basis Weakness)

Table 4 is used to describe the actions a hedger would take and the outcomes of those actions in placing an output hedge in which the futures price increased by more than the cash price during the hedging period. In this scenario basis is said to weaken. Following from table 4, suppose today you could sell live cattle for $64/cwt. and the relevant futures contract is trading for $65/cwt. (basis is $1.00 under). Knowing that you will sell cattle at a later date and you want to protect against a price decrease, you take a short position in the futures market at this time. Over the next few months the local cash price increases to $67/cwt. and the futures price increases to $69/cwt. At this time you decide the cattle need to go to market. You sell cattle in the cash market for $67/cwt. and buy back your futures position for $69/cwt. Therefore, the revenue from selling cattle is $67/cwt. less $4/cwt. lost from the futures position less any commission. Instead of selling for $67/cwt. you sell for $62.85/cwt.

3. Futures Price Increases at the same rate as the Cash Price

Under this scenario the price you pay is exactly equal to the price you would have paid earlier with the exception of commissions ($0.15/cwt). Again, there is no change in the basis in this example so the net price received is exactly equal to the original price less commissions.

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