Hedging With Futures

Many businesses face price risk when their activities require them to hold a working inventory. For example, suppose you own a regional gasoline distributorship and must keep a large operating inventory of gas on hand, say, 5 million gallons. In futures jargon, this gasoline inventory represents a long position in the underlying commodity.
If gas prices go up, your inventory goes up in value; but if gas prices fall, your inventory value goes down. Your risk is not trivial, since even a 5-cent fluctuation in the gallon price of gas will cause your inventory to change in value by $250,000. Because you are in the business of distributing gas, and not speculating on gas prices, you would like to remove this price risk from your business operations. Acting as a hedger, you seek to transfer price risk by taking a futures position opposite to an existing position in the underlying commodity or financial instrument. In this case, the value of your gasoline inventory can be protected by selling gasoline futures contracts.
Gasoline futures are traded on the New York Mercantile exchange (NYM), and the standard contract size for gasoline futures is 42,000 gallons per contract. Since you wish to hedge 5 million gallons, you need to sell 5,000,000 / 42,000 = 119 gasoline contracts. With this hedge in place, any change in the value of your long inventory position is canceled by an approximately equal but opposite change in value of your short futures position. Because you are using this short position for hedging purposes, it is called a short hedge.
By hedging, you have greatly reduced or even eliminated the possibility of a loss from a decline in the price of gasoline. However, you have also eliminated the possibility of a gain from a price increase. This is an important point. If gas prices rise, you would have a substantial loss on your futures position, offsetting the gain on your inventory. Overall, you are long the underlying commodity because you own it; you offset the risk in your long position with a short position in futures.
Of course, your business activities may also include distributing other petroleum products like heating oil and natural gas. Futures contracts are available for these petroleum products also, and therefore they may be used for inventory hedging purposes.
The opposite of a short hedge is a long hedge. In this case, you do not own the underlying commodity, but you need to acquire it in the future. You can lock in the price you will pay in the future by buying, or going long in, futures contracts. In effect, you are short the underlying commodity because you must buy it in the future. You offset your short position with a long position in futures.