Hedging is based on the principle that cash market prices and futures market prices tend to move up and down together. This movement is not necessarily identical, but it usually is close enough that it is possible to lessen the risk of a loss in the cash market by taking an opposite position in the futures market.
Taking opposite positions allows losses in one market to be offset by gains in the other. In this manner, the hedger is able to establish a price level for a cash market transaction that may not actually take place for several months.
The Short Hedge.
To give you a better idea of how hedging works, let’s suppose it is May and you are a soybean farmer with a crop in the field; or perhaps an elevator operator with soybeans you have purchased but not yet sold. In market terminology, you have a long cash market position. The current cash market price for soybeans to be delivered in October is $9.00 per bushel. If the price goes up between now and October, when you plan to sell, you will gain.
On the other hand, if the price goes down during that time, you will have a loss. To protect yourself against a possible price decline during the coming months, you can hedge by selling a corresponding number of bushels in the futures market now and buying them back later when it is time to sell your crops in the cash market.