How Hedgers Utilize Basis
The basis affects both short and long hedgers. Basis risk – that cash and futures prices may change by different amounts – is a concern to hedgers, as fluctuations in basis make for a less than complete hedge.

The Short Hedge
It is July and the cash price for corn is 170 cents/bushel. A farmer wants to be sure to get the best price for her corn. She could sell it for cash, or she could enter into a futures contract to deliver it for 200 cents/bushel in September. The choice would seem apparent. But she knows from historical data that, between September and December, the basis has always strengthened and that, ultimately, the basis this time of year is generally 40 under December. With this year's price levels, that suggests a December futures price of 210 cents/bushel, and she would write a contract to lock in that price.

Short hedgers are long the basis as they are long the actuals. This means that they own or will own a commodity that they hedge by shorting futures. If basis strengthens (the gap between the futures and cash price decreases), the hedger's effective selling price is greater than the cash price that he or she is looking to protect.

In a short hedge, the hedger sells a futures contract to protect against falling prices. Assuming that prices decline, the short hedger makes money on the futures sale which compensates for losses on the actuals. If prices increase, the futures position loses, but the cash position gains.

The Long Hedge
This type of hedge either protects a future cash purchase or short (unowned) position in the underlying commodity. An example of the latter would be a promise to sell goods yet to be purchased by a middleman or produced by a manufacturer. The long hedger purchases futures, as he or she does not have the underlying good that she will have eventually to deliver at what she hopes is a profit. A long hedger is short the basis and wants weakening basis. A decrease in the spot price relative to the futures price advantages the long hedger as it decreases the net cost of assets purchased, which is the cash price on the day that the hedge is put on, less the degree to which basis weakened.

A flour miller will need wheat to produce flour. He purchases wheat futures. A rise in wheat prices increases the cost of his input and reduces his profit. However, the profit on the long futures position offsets the increased cost of wheat. The long position locks in the cost of wheat that he will need to buy in order to produce and sell flour, which he has already agreed to do.

Formula
Futures price + expected basis = expected buying price
Effects On Commodity Delivered Or Purchased

Related Articles
  1. Investing

    Why Hedge Funds are Mass-Selling Agricultural Futures

    An oversupplied wheat market, speculation about Federal Reserve shifts to interest rates, and other factors have contributed to the large-scale shift.
  2. Investing

    An Introduction To Real Estate Futures

    These futures are intended for institutional use, but retail investors looking to speculate on prices can benefit as well.
  3. Trading

    The Difference Between Forwards and Futures

    Both forward and futures contracts allow investors to buy or sell an asset at a specific time and price.
  4. Investing

    What Determines Oil Prices?

    Changes in the price of oil aren't arbitrary. Read on to find out what moves them and why.
  5. Investing

    Fueling Futures In The Energy Market

    The energy market influences every aspect of our lives, and these four options are its driving force.
  6. Investing

    Short Selling Risk Can Be Similar To Buying Long

    If more people understood short selling, it would invoke less fear, which could lead to a more balanced market.
  7. Trading

    Guide to Short Selling

    Want to profit on declining stocks? This trading strategy does just that.
Frequently Asked Questions
  1. Why Do a Reverse Merger Instead of an IPO?

    Reverse mergers are often the most cost-efficient way for private companies to trade publicly.
  2. Determining a Firm's Percentage of Credit Sales

    Find out where to look for information about determining a company's percentage of credit sales.
  3. What Does the Diluted Share Price Reveal?

    Learn how diluted share price affects earnings and the company's overall financial performance.
  4. How Can Institutional Holdings Be More Than 100%?

    No entity can own more than 100% of a company's outstanding shares, but it can be reported that way.
Trading Center