One of most valued tools in the futures markets is hedging which is commonly used and is still used by the traders of Futures today.
Hedging is when one assumes that a movement in the cash or current prices in the futures will match against each other when after certain adjustments are done. These will usually be done upon a particular season or after a highly specific trend within the cash market. The goal of the trader is to lock on a price so that they will lower the risk of exposing themselves on short term fluctuations on the prices.
The different seasons are highly influential on the futures markets which deal with agricultural products among others. Take for example an exceedingly long hot or dry climate that affects the rice production of an Asian country. The different companies that deal with the processing of grain will have cause for concern if there is not enough rice supply.
Other factors which can get affected with the rice productions will be: banks, the rice buyers and traders, the families who produce the rice and others. In fact, the economy of that area where the rice is produced will get affected as well. If the prices of the rice start to increase dramatically, the ‘cash market,” those who buy in cash, not credit, will also get affected.
Knowing these factors will have an influence on the trader – if the prices can soar, they can also lower considerably once the crops are harvested. This can occur when a government takes a chance by releasing grain from the grain reserves or by importing rice from other countries. These foreign imports will considerable lower the price of rice much faster than the released grain supply. So whatever happens, you, the trader, have to sell based on the present price of rice.
You may either get into a contract or sell the grain to a firm which will quote prices upon the beginning of the harvest. Usually, however, these prices will be lower than the market prices. The other choice would be to sell the crop to the Futures Market where the prices would most likely not get manipulated. Here, you may not get your cash as fast, but then your price will be locked, even if the prices in the market drop drastically, you will only receive the money which was agreed upon. However, this is also double edged; if the prices in the market dramatically increase, your locked price at a lower rate can mean you lose money.
In the Futures Market, hedging can come in when and if you decide not to make a move in the hope that the prices will go in your favor.