The Hedging Concept
Producer hedging involves selling corn futures contracts as a temporary substitute for selling corn in the local cash market. Hedging is a temporary substitute, since the corn will eventually be sold in the cash market.
Hedging is defined as taking equal but opposite positions in the cash and futures market. For example, assume a producer who has harvested 10,000 bushels of corn and placed it in storage in a grain bin. By selling 10,000 bushels of corn futures the producer is in a hedged position. In this example, the producer is long (owns) 10,000 bushels of cash corn and short (sold) 10,000 bushels of futures corn.
Since the producer has sold futures, price has been established on the major component of the local cash price which illustrates that the futures component is the most substantial portion of the local cash price.
Selling futures in a hedge leaves the local basis unpriced. Thus, the final value of the corn is still subject to fluctuations in local basis. However, basis risk (variation) is much less than futures price risk (variation). By selling futures, the producer has eliminated the financial loss which would occur on the cash grain from a futures price decline.
The hedge position is removed or lifted when the producer is ready to sell the corn in the cash market. It is lifted in a simultaneous two-step process. The producer sells 10,000 bushels of corn to the local grain elevator and immediately buys back the futures position. The purchase of futures offsets the original short (sold) position in futures, and selling the cash grain converts the position to the cash market.