There are two main participants within a futures market. Hedgers and Speculators. Hedging and Speculating are done for different reasons.
Hedging is done to manage price risk. Hedgers wish to protect themselves from unfavorable price movement by foregoing a profit if the price moves in their favor. There are different reasons why hedging might be undertaken. A wheat farmer can hedge against a possible price decline in the future and on the other hand a cookie maker can hedge against an increase in the price of wheat in the future. A lender can hedge against a possible decline in the interest rate, whereas a borrower can hedge against a possible increase in the interest rate. To hedge, you either have the underlying commodity (ie. Farmer) or you require the underlying commodity at some point in the future (ie. Baker)
There are two type of hedging:
Here the producer of a particular commodity wants to ensure that they get at least a given price in the future. If the price of a bushel of wheat for a December contract is currently $8.50 and the farmer feels that due to whatever reasons he might not be able to get more than this price in the future, he can enter into a contract to sell wheat at $8.50/bushel in December. Let us suppose that he has made a contract of 10,000 bushels. If the price of wheat in December is $8.10/bushel he would still be getting $8.50/bushel as per the contract. Hence the final amount he is able to get is $85,000($8.50*10000). If he did not hedge he would have got $81,000 by selling the wheat in the open market. Hence he is able to get a profit of $4,000 and is able to protect his income through hedging. On the flip side if the open market price of wheat increases to $9.50/bushel he would have made $95,000 by selling the wheat in the open market. But because of the contract he is able to get only $85,000 giving him a loss of $10,000. Besides the profit the major advantage is that he knows the amount he will get on his crop which allows him to plan accordingly for the season.
A jeweler can hedge for Gold as a consumer of the commodity. If gold is trading at $1200.00 per troy ounce in the 6 month future contract and the jeweler feels that the price of gold will increase he can purchase a contract to buy gold at $1200.00 6 months from now. This way if the price of gold increases he will be protected from the unfavorable price movement as a consumer of the commodity. Let us say that the price of gold increases to $1260.00 in 6 months and he has purchased a contract to buy 100 troy ounces of gold. He will have to give $120,000 to purchase the gold instead of spending $126,000 in the open market. Hence he has been able to reduce his cost by $6,000. However if the price of gold decreases to $1,150 in 6 months he still has to spend $1,200 per troy ounce to purchase gold. Here his net loss would be $5,000. Again here the major benefit is that it will allow smoother functioning of his operations. Due to sudden changes in the market he does not have to change his operations.
Types of hedgers:
Commodity producers: They are looking to get a known return on their product and hence hedge against sudden decrease in price of their commodity.
Commodity consumers: They are looking to ensure they get the commodity at a given price and hence want to protect themselves against sudden increase in the price of a commodity.
Portfolio managers: Investment fund managers of mutual funds, managed equity funds, superannuation funds, etc. can hedge against sudden swings in the market and to protect their overall market portfolio.
Hedge Funds: There are specialized hedge funds which use numerous strategies to maximize returns for their investors and to achieve their investment objectives. Participation in futures market helps them balance their strategies and manage risk.
The other part of futures market is made of speculators. They provide liquidity to the market. If a farmer wants to short sell a contract for 5,000 bushels of wheat expiring in 3 months it is highly unlikely that he will immediately find another consumer who wants to long buy a similar amount of wheat at the same time. The speculators, although they do not have any interest in the underlying asset or commodity, still buy the contract looking to profit through ideal market timings. This helps the entire system by bringing in much needed liquidity.
There are two types of speculators:
If a speculator believes that the price of a commodity will increase in the future he will buy or “go long” a futures contract. If the price does increase in the future he will be able to get a profit by selling the contract at a higher price. For example a trader believes that the value of crude oil will increase in the future. The current price for a December contract of 1000 barrels is $90 per barrel. In 2 weeks the price of the contract increases to $92 per barrel. Selling the contract in two weeks will give him a profit of $2,000. However if the price of the contract decreases he stands to lose.
If a speculator believes that the price of a commodity will decrease in the future he can sell a futures contract now. When the price has decreased he can buy back the contract at a lower price to cover his position. For example a trader sells a December contract of 1000 barrels for crude oil at $88 per barrel. In 1 week the price of oil decreases to $85, he can now buy the contract and effectively cover or offset his position. This will give him $3 per barrel profit or $3,000 profit on the entire contract. Generally stop-loss and several other strategies are used to ensure that the losses are not magnified and one can get good returns from the trade.
The speculators bring additional information in the market and by having varying positions of buying and selling help in the price discovery process in the market.
Categories of Speculators:
Individual traders: Through the use of electronic trading many individual traders can now easily and at low cost participate in the futures market. With the easy access of information it has become possible for them to do proper research and analyses and make profitable trades.
Prop Traders: Proprietary trading firms provide their traders with funds and the system, using which they can trade according to specified strategies.
Hedge funds: They work on a large number of contracts simultaneously and look to provide better returns to their investors as well as look to better manage their risk.
Market Makers: These firms are continually providing bid-and-offer prices by adding liquidity to the market. They generate profit through the bid/offer spread over a large number of transactions.
While trading there are different techniques used which might include fundamental analysis (analyzing the core information regarding the asset or commodity to find how the market will react in the future) and technical analysis (using charts and graphs to find varying strategies to make profit). There are different types of traders like position traders, day traders, scalpers, etc. and using one or more strategies they try to make profitable trades.
There is a use of all the different players within the market. Some provide added liquidity others provide the requisite commodity which makes it possible for a futures exchange to work transparently, credibly and efficiently.
Introduction to the Futures Market Tutorial
1) Introduction to the Futures Market
2) History of the Futures Market
3) How the Futures Market Works
4) Difference between a Forward and Futures Contract
5) Participants in the Futures Market
6) Main factors that impact Futures Prices
7) What is a Futures Clearing House?
8) Risks in the Futures Market