A hedgers buys futures contracts, taking a long position in the wheat futures markets. What are hedger’s obligations under this contract? Describe the risk that is hedged in this transaction, and give an example of someone who might enter into such arrangement.
A baker is a perfect example of someone who would take a long position in a futures contract on wheat. If the baker can pay the spot price projected for a 3-month futures window but could not pay a higher price, then the baker will hedge (or protect) his investment in his bakery business by going long and locking in the 3-month future wheat price. In 3 month's time, he will be happy to take delivery of the wheat at the contracted price. The risk is that wheat prices might go against the trend and actually go down. In this event, the baker will pay more than if he had not hedged with the futures. However, if he does not hedge with a futures contract and the wheat price spikes upward, he may risk much worse than a higher-than-market price on his wheat.
Hedging in this way is a big risk, because you are committing yourself to buying a certain product, in this case grain, at a certain price in the future. What you are gambling on is that the price of grain will go up and therefore you will buy cheap grain that you can then sell on at a profit. However, of course there is the risk that the price of grain will go down and you will be left paying a higher price for it than the current market value.
There are so many different ways to play options. As stated above, you can agree to buy a stock at a certain price in the future. In this case you would buy a call option for a future date. However, you can do so many other things. If you do not want to hold the stock or commodities, you can sell a put option and obligate yourself to only buy the stock at an agreed price. In this way, you collect the premium. Also keep in mind that you can close options at any time.
When you buy long in commodity futures, you are betting that the price of whatever commodity you buy will be going up. It really is a bet, because there is no way to really know the price of something in the future. If the price goes down, you are obligated to pay!
The obligation is to buy some amount of wheat from at some point in the future. The risk in this transaction is that the price of the wheat will go down between now and the time that you actually buy the wheat. In such a case, you lose because you have bought for a higher price than you will be able to get for the wheat.