Hedging, Basis, and Spreads
Hedgers use futures to transfer price risk that arises from their cash-market business. This chapter explains long and short hedges, how basis links cash and futures prices, and how spread positions profit from changes in price relationships rather than outright direction.
Short Hedges and Long Hedges
A short hedge protects against falling prices: a producer or holder of the physical commodity (a farmer with grain, a lender holding bonds) sells futures so that a decline in the cash price is offset by a gain on the short futures. A long hedge protects against rising prices: a user or future buyer of the commodity (a food processor, a manufacturer) buys futures so that a rise in the cash price is offset by a gain on the long futures. The hedger accepts giving up some favorable moves in exchange for reduced uncertainty.
Basis
Basis is the cash (spot) price minus the futures price for a given delivery month at a given location. A hedge does not eliminate risk entirely; it converts price risk into basis risk. When basis strengthens (becomes more positive or less negative), it helps the short hedger; when basis weakens, it helps the long hedger. As delivery approaches, cash and futures prices converge, so basis tends toward zero at expiration for a deliverable contract.
Spreads
A spread is the simultaneous purchase of one futures contract and sale of a related one to profit from a change in the price difference between them. Intramarket (calendar) spreads trade two delivery months of the same commodity. Intermarket spreads trade related commodities, and interexchange spreads trade the same commodity on different exchanges. Because the two legs tend to move together, spreads generally carry lower risk and lower margin than an outright position.