Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price. The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price.
The ultimate goal of an investor using futures contracts to hedge is to perfectly offset their risk. In real life, however, this can be impossible. Therefore, individuals attempt to neutralize risk as much as possible instead.
For example, if a commodity to be hedged is not available as a futures contract, an investor will buy a futures contract in something that closely follows the movements of that commodity.
Using Futures Contracts to Hedge
When a company knows that it will be making a purchase in the future for a particular item, it should take a long position in a futures contract to hedge its position. For example, suppose that Company X knows that in six months it will have to buy 20,000 ounces of silver to fulfill an order. Assume the spot price for silver is $12/ounce and the six-month futures price is $11/ounce. By buying the futures contract, Company X can lock in a price of $11/ounce. This reduces the company's risk because it will be able to close its futures position and buy 20,000 ounces of silver for $11/ounce in six months.
If a company knows that it will be selling a certain item, it should take a short position in a futures contract to hedge its position. As an example, Company X must fulfill a contract in six months that requires it to sell 20,000 ounces of silver. Assume the spot price for silver is $12/ounce and the futures price is $11/ounce. Company X would short futures contracts on silver and close out the futures position in six months. In this case, the company has reduced its risk by ensuring that it will receive $11 for each ounce of silver it sells.
Futures contracts can be very useful in limiting the risk exposure that an investor has in a trade. The main advantage of participating in a futures contract is that it removes the uncertainty about the future price of an item. By locking in a price for which you are able to buy or sell a particular item, companies are able to eliminate the ambiguity having to do with expected expenses and profits.
How Are Futures Used To Hedge A Position?
Exiting a Position Before Expiration
While a futures contract is similar to an option—where the holder has the right to purchase the underlying security—a futures contract makes both parties to the contract obligated to deliver on the terms of the contract if it is held to settlement. If you do buy a futures contract, you are entering an agreement to purchase the underlying security and if you sell a futures contract you are entering an agreement to sell the underlying asset to another party.
Over the life of a futures contract, the underlying security will likely move in favor of one holder over the other. So what can the holder with the profit do if they would rather exit the profitable position than hold to settlement? If a futures trader wants to close out a position, all they need to do is take an equivalent position that is opposite to the contract that they already own. So if you are long three February pork belly contracts, you would sell three February pork belly contracts to close this position.
However, this is not usually done by just selling your existing three contracts to another party, like you would a stock. The positions are usually closed out by entering into a new arrangement with another party.
For example, if you purchased three contracts from party A, in order to close out your position, you would sell three contracts to party B. Since these positions are offsetting, your position in the market is neutralized, and you are effectively out of the position. While this is a little more complicated than just selling the original three contracts, the result is the same.