Contrary to alternative investment management strategists, most of the hedgers seek to use futures markets to minimize a specific risk that they can run into. Such a risk can be related to volatility in the price of oil, the level of the stock market or other variables. Ideal hedge is one that entirely removes the risk. However, in the real world ideal hedges are very rare. Investors who use hedging strategies in the futures markets try to construct their portfolio so that they as close to as possible to ideal ones. There are two types of hedges: short and long. A short hedge incorporates a short position in futures contracts. Such hedging strategy should be used when the hedger already owns an asset and hopes to sell it at some point in the future. If a farmer raises chickens and knows that they will be ready for sale in 6 weeks, he can use a short hedge strategy. Contrary to alternative investment management strategies, a short hedge can be used for assets which will be owned at some point in the future. For example, a UK exporter knows that he will receive US dollars in 2 months. This exporter will realize a profit if the euro increases in value relative to the UK pound, and vice versa if the euro decreases in the value relative to the UK pound. A long hedge incorporates a long position in futures contracts. Such hedging strategy should be used when a company knows that it will have to buy a certain asset in the future and thinks about locking in a price now. Let’s assume that it is now the 1st of November and a cotton manufacturer knows it will need 200,000 US dollars of cotton on the 1st of February to meet a particular contract. The spot price of cotton is 61.80 in US cents per pound, and the futures price for February delivery is 60.20 in US cents per pound. The manufacturer can hedge its position by taking a long position in four futures contracts by the CME Group and closing its position on the 1st of February. If the price of cotton on the 1st of February is 60.30 cents per pound, the manufacturer will gain:

200,000 x ($60.3 – $60.20) = $20,000

However, if everything goes vice versa and the spot price is 60.15 in US cents per pound, the manufacturer then loses:

200,000 x ($60.20 – $60.15) = $10,000

In this case, it is better for the manufacturer to use futures contracts, rather than to buy the cotton on the 1st of February in the spot market.