# Long Hedge: What It Is, How It Works, Example

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> **Definition**
>
> A long hedge is a futures position taken to lock in a future price of a commodity or raw material. This strategy helps protect against price increases by allowing the buyer to secure a set price in advance.

As cocoa beans more than doubled in price from 2024 to 2025, what could a chocolate manufacturer do, knowing it would need to source more cocoa in the coming months? Enter the long hedge, a financial tool that helps companies lock in future prices.

A long hedge is when a company enters into a futures contract to protect against potential price increases on materials they know they'll need to buy later. For example, an airline might use long hedges to guard against rising jet fuel prices, while a jewelry maker might hedge against increasing gold prices.

By taking a long position in futures contracts, companies set a ceiling on what they'll pay for materials months in advance. This helps businesses better predict their costs and protect their profit margins, even when the market for goods is volatile.

*   Long hedges protect buyers against rising prices by locking in future costs through futures contracts.
*   The effectiveness of a long hedge depends on the hedge ratio—the percentage of the total purchase that is hedged.
*   Long hedges work like insurance policies: there's a cost, but it protects against adverse price shifts.
*   While long hedges can't eliminate all pricing risks, they can significantly reduce volatility.

## Understanding Long Hedges

When companies know they'll need [raw materials](https://www.investopedia.com/terms/r/rawmaterials.asp) in the future, they often worry about prices going up before they can buy. A long hedge helps solve this problem. It's when a company buys futures contracts that will increase in value if prices rise, offsetting the higher cost they'll pay for materials when they go to buy them.

Futures contracts are regulated financial instruments that trade on specialized exchanges like the Chicago Mercantile Exchange (CME). When you enter into a [futures contract](https://www.investopedia.com/terms/f/futurescontract.asp), you're making a legally binding commitment to buy or sell something at a specific price on a future date.

These contracts have become essential tools in modern finance, from food companies hedging agricultural commodity prices to investors seeking to profit from price movements. It's like buying insurance on your future purchases. If prices increase, the insurance (your futures contract) pays off and helps cover the extra cost. If prices drop, you lose money on the insurance but save money on the purchase of the goods.

The strategy is particularly popular among manufacturers who regularly need specific raw materials such as copper, aluminum, or wheat. Airlines also commonly use long hedges to protect against rising jet fuel prices.

> **Fast Fact**
>
> For consumers, long hedges are important. Without them, many producers would struggle to sell their products at consistent prices.

## Example of a Long Hedge

Let's say a cookie manufacturer knows they'll need 10,000 pounds of sugar in six months. Sugar is currently $0.50 per pound, but prices have been rising and company management is worried they might go up even more.

Here's how a long hedge would work:

*   Current price (January): $0.50/pound
*   Futures delivery price (July): $0.55/pound
*   Amount needed: 10,000 pounds

The manufacturer buys futures contracts for 10,000 pounds of sugar at $0.55 per pound, for delivery in July. Now, let's look at two scenarios:

**Scenario 1: Prices Rise**

*   July sugar price rises to $0.65 per pound, up from $0.50 per pound in January
*   Added cost of the physical purchase: $1,500 (paying $0.15 more per pound)
*   Profit on the futures contract: $1,000 (contract worth $0.10 more per pound)
*   Net cost increase: Only $500 instead of $1,500

**Scenario 2: Prices Fall**

*   July sugar price falls to $0.45/pound, down from $0.50 per pound in January
*   Savings on the physical purchase: $500 (paying $0.05 less per pound)
*   Loss on the futures contract: $1,000 (contract worth $0.10 less per pound)
*   Net result: A higher cost, but protected against potentially worse price increases

## Hedge Ratios

An important aspect of this type of financial trading is the hedge ratio. This ratio shows how much protection a company has against price changes. For example, if a cookie company knows they'll need 10,000 pounds of sugar in the future, they might decide to hedge 80% of that amount through futures contracts, making their hedge ratio 80%.

A 100% hedge ratio means a company has sought protection for its entire expected purchase or sale. A 50% ratio means it's hedged half of it. Companies rarely use 100% hedge ratios because they want to maintain some flexibility and avoid over-hedging—akin to buying too much insurance on your car.

Several factors influence how companies choose their hedge ratios:

*   **Market volatility**: More volatile markets often lead to higher hedge ratios.
*   **Storage costs**: Higher storage costs might lead to lower hedge ratios.
*   **Budget constraints**: The cost of hedging can limit how much protection a company buys.
*   **Risk management policies**: Companies with conservative risk management policies typically use higher hedge ratios.

> **Tip**
>
> The perfect hedge ratio doesn't exist—it's about finding the sweet spot between protection and flexibility.

## How Companies Set Long Hedge Prices

When companies decide what price to use for futures contracts, they don't just pick numbers out of thin air. Instead, they rely on a concept called the "[cost of carry](https://www.investopedia.com/terms/c/costofcarry.asp)" model, which considers key factors that affect pricing.

The basic formula starts with the current market price (called the [spot price](https://www.investopedia.com/terms/s/spotprice.asp)) and adds in various costs:

*   Storage for holding the physical commodity
*   Insurance to protect stored goods
*   Financing (interest rates)
*   Any income that might be earned from holding the asset

For example, if gold is trading at $2,600 per ounce and the annual interest rate is 5%, a one-year futures contract might be priced around $2,750 to account for the cost of financing the purchase for a year. This gets more complex when dealing with commodities with seasonal patterns, like agricultural products, or those with significant storage costs, like oil.

Companies in different markets use different pricing conventions and factors. A table going over some of these is below.

## Hedging With Marketing vs. Futures Contracts

When farmers and other commodity producers need to protect themselves against price swings, they have two main tools: marketing and futures contracts. While both help manage risk, they work quite differently.

### Marketing Contracts

Akin to [forwards](https://www.investopedia.com/terms/f/forwardcontract.asp'), marketing contracts are direct agreements between commodity producers and buyers, like grain elevators or food processors and farmers. They act as a preordering system: the producer and buyer agree upfront on details like price, quantity, and delivery date. These contracts are customized, so, for example, a dairy farmer might arrange to sell 10,000 gallons of milk at $3.50 per gallon, delivered monthly over six months.

> **Fast Fact**
>
> Small farmers and similar commodity producers often prefer marketing contracts because they don't have to worry about margin calls or complex trading strategies.

### Futures Contracts

Futures contracts, meanwhile, are standardized agreements traded on exchanges like the [CME](https://www.investopedia.com/terms/c/cme.asp). Unlike marketing contracts, futures contracts have fixed terms—for example, all full-size CME corn futures contracts are for 5,000 bushels. They're more like buying insurance against price changes than making actual delivery arrangements.  

## What Are Short Hedges?

A short hedge involves [shorting](https://www.investopedia.com/terms/s/short.asp) an asset or using a derivative contract that hedges against potential losses from price declines by selling at a specified price. When a company knows they'll sell a product in the future, they can use short hedges to lock in the price today.

For example, an oil producer might use short hedges to ensure they can sell their future production at today's prices, protecting against price drops. This strategy is common in agricultural and natural resource industries where producers want to secure their revenue streams well in advance of production.

## What's the Difference Between Long and Short Hedges?

Long and [short hedges](https://www.investopedia.com/terms/s/short_hedge.asp) both protect against price changes. Long hedges protect buyers who worry about prices rising because they'll need to buy materials later, while short hedges protect sellers who worry about prices falling because they plan to sell products later.

## Which Companies Typically Use Long Hedges?

[Manufacturers](https://www.investopedia.com/terms/m/manufacturing.asp), food processors, airlines, and other businesses that regularly need to purchase commodities or raw materials as inputs for their operations are the primary users of long hedges. Companies that use long hedges typically have regular, predictable needs for specific [commodities](https://www.investopedia.com/terms/c/commodity.asp) and want to avoid the uncertainty of market prices.

## Which Companies Engage in Short Hedges?

Short hedges are primarily used by producers and companies that know they'll need to sell products in the future. Beyond raw material producers, manufacturers sometimes use short hedges when they have large orders with delayed delivery dates. For example, a steel manufacturer might use short hedges when it has agreed to deliver products six months from now but at today's prices. [Energy companies](https://www.investopedia.com/terms/e/energy_sector.asp) also commonly employ short hedges—oil producers might hedge their future production, while renewable energy companies might hedge their future electricity sales.

## The Bottom Line

Long hedges are a crucial [risk management tool](https://www.investopedia.com/terms/r/riskmanagement.asp) for companies that need to buy commodities or raw materials regularly.  By using futures contracts to secure prices, buyers can protect themselves against rising costs and stabilize their prices in turn.

However, long hedges aren't without risks. If market prices fall below the locked-in price, the hedger may face higher costs than simply buying on the spot market. For this reason, long hedges are most effective when carefully aligned with an organization's production needs and market outlook.  

> **Article Sources**
>
> 1.  University of Missouri Extension. “[Long Hedge Example With Options](https://extension.missouri.edu/publications/g609).”
>     
> 2.  FasterCapital. “[Hedging Strategy: Mastering Hedging Strategies: Longhedge Essentials](https://fastercapital.com/content/Hedging-strategy--Mastering-Hedging-Strategies--Longhedge-Essentials.html).”
>     
> 3.  Prager, Daniel, Christopher Burns, Sarah Tulman, and James MacDonald. "[Farm Use of Futures, Options, and Marketing Contracts](https://www.ers.usda.gov/webdocs/publications/99518/eib-219.pdf)." _Economic Information Bulletin_ (USDA), no. 219.
>     
> 4.  H. Geman. "[Agricultural Finance: From Crops to Land, Water and Infrastructure.](https://www.wiley.com/en-us/Agricultural+Finance%3A+From+Crops+to+Land%2C+Water+and+Infrastructure-p-9781118827383)" John Wiley & Sons, 2015. Pages 50-55.