Speculating or Hedging Using Futures Contracts

There are two basic types of participants in the futures markets: speculators and hedgers.

Speculators are those negotiators that buy and sell futures contracts without the intention of taking delivery of a commodity or financial security. In other words, they short-term negotiators of futures contracts (taking short or long positions) based on their evaluations in the direction that future prices will take.

Great speculators are generally constituted by fund managers, and the small speculators are individual negotiators which assume the greatest volume of negotiations.

Hedgers are negotiators that look to protect themselves from fluctuations in prices through the taking of opposite positions. In other words negotiators look to reduce loss risks before price fluctuations in commodities and the financial securities through the taking of a long and short position.

Some examples of hedgers are the soy farmers , importers, exporters and stock portfolio managers that look to protect themselves from fluctuations in prices in their respective positions in underlying commodities and financial securities.

For example, corn farmers are aware of their costs to harvest corn and would like to get profits for their efforts. If the cost to harvest a bushel of corn is of $2.25 and the date of delivery is in March and the corn futures contracts are being negotiated at $2.40 per bushel a corn farmer can close in a profit of $0.15 per bushel. The farmer would sell the March futures contract for $2.40 per bushel, and the buyer would accept the delivery of 5000 bushels (the contract size) in March. If the price of corn falls to $2.20 per bushel the farmer would close with a profit of $0.15 per bushel because the buyer of the contract pays the amount of $2.40 per bushel. However, if the price of corn increases to $2.50 per bushel, the corn farmer would only receive $2.40 per bushel. In this case it is the buyer who benefits when prices of corn futures increase above $2.40.

The buyer pays the price of the contract $2.40 per bushel and immediately after can sell the corn in the cash market for $2.50 per bushel, achieving a benefit of $0.10 per bushel.

That is how commodity users can benefit through hedging from their positions in an opposite direction. If a jeweler needs 100 ounces of gold in a three month period of time, he could wait during three months and later buy the gold in the cash market at the current price. Another option would be to hedge against prices in raise using futures contract .

If a gold futures contract with a delivery of three months time is being negotiated at $440 per ounce. If gold raises above the $440 per ounce, the jeweler has hedged his position successfully and will not have to be afraid for the money because of an additional raise in gold price that is above $440 per ounce.

However, if gold drops below $440 per ounce, the jeweler could lose money. For example, the price drops to $430 and he sells the contract losing $10 per ounce, the jeweler can then buy gold in the cash market at $430 per ounce.

That is why, hedgers are also involved in the cash market. A commodity?s or financial security cash price is the price for the current delivery which is also denominated as spot price. The cash price differs from futures price, which is the price of a contract for future delivery of a commodity or financial security. The difference between cash and the futures prices is known as the basis.

Generally, futures prices are larger than those of cash prices, reflecting itself in time until delivery, the  storage costs of the commodity, and the rates of interests (opportunity cost).

The difference between futures and cash prices are reduced with the closeness to delivery time.