Hedging with Futures — The Original Use Case

Summary

Hedging is why futures exist. Airlines hedge fuel; farmers hedge harvests; funds hedge equity beta.

The airline case study

An airline burning 200 million gallons of jet fuel a year has a huge exposure to crude oil prices. By buying crude oil futures for delivery over the next 12 months, it can effectively lock in today's price. If oil rips higher, the futures profit offsets the higher physical fuel cost.

The farmer case study

A corn farmer plants in May and won't harvest until September. By selling corn futures for September delivery in May, the farmer locks in the price today. If corn falls between May and September, the futures gain offsets the lower cash sale.

Portfolio hedging with equity index futures

A fund manager who owns $50 million of large-cap stocks can hedge that exposure by shorting E-mini S&P 500 futures. With the index at 5,000 and each contract at $250,000 notional, they'd short 200 contracts to fully neutralise. This is why S&P futures see billions in daily volume during equity drawdowns.

The hedge is never perfect

Basis risk (difference between futures and physical price) always exists. Jet fuel is not crude oil. A specific corn variety is not the generic contract. Portfolio betas drift. Hedges reduce risk — they never eliminate it.

(Educational simulation only — not financial advice. Practice everything below with $100,000 virtual cash on TradeHQ.)

Key takeaways

• Hedging is the original purpose of futures.
• Producers sell; consumers buy.
• Equity funds hedge beta by shorting index futures.
• Basis risk means hedges reduce — never eliminate — risk.

Check your understanding

• A wheat farmer worried about price drop should: Options: Buy wheat futures; Sell wheat futures; Buy corn futures; Buy S&P. Correct answer: Sell wheat futures. Why: Sell to lock in today's price.
• Airline hedging vs crude rally should: Options: Sell crude futures; Buy crude futures; Buy S&P; Do nothing. Correct answer: Buy crude futures. Why: Buying futures profits if crude rises.
• Basis risk is: Options: Exchange default; Futures vs physical don't move perfectly together; Rate risk; FX risk. Correct answer: Futures vs physical don't move perfectly together. Why: Basis fluctuates.
• Hedge $50M with $250K notional contracts → Options: 20; 200; 500; 1,000. Correct answer: 200. Why: $50M / $250K = 200.

Sources

• CME — Hedging (https://www.cmegroup.com/education/courses/hedging-with-futures.html)
• USDA — Farm Risk (https://www.usda.gov/topics/farming/risk-management)

Practise this lesson

Open the practice desk and apply this lesson immediately with $100,000 in virtual cash. Concepts become usable when they are rehearsed under simulated conditions, not when they are read. Educational simulation only — not financial advice.