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In this lesson we'll introduce the two principle groups that trade futures contracts. Essentially, there are two types of futures market participants: hedgers and speculators. Both have different motives, yet both play critical roles.
As explained in the history of futures trading, futures markets were developed in order to accomodate the needs of hedgers, which is the desire to offset price risk. Yet, these markets could not exist without speculators. Futures markets rely upon both parties in order to operate efficiently.
But, before we discuss the futures market players it is necessary to talk about two important facts.
1Producers and consumers of commodities can buy or sell their commodities on the cash market at any given time. The cash market simply means the market where private transactions of a commodity take place in the present. For instance, a farmer (a producer of a commodity) can sell his corn supplies to a buyer at any given time in the present, without using the futures markets. Likewise, a consumer (meaning a manufacturer that uses a commodity to produce a product) that uses petroleum to manufacture plastics can buy supplies of oil in the cash market. Furthermore, the rise and fall of commodity prices in the cash markets and futures markets move in tandem with each other (more or less).
Understanding this will help you understand the purpose of hedgers.
2You must understand that commodities are risky things. I'm not talking about the risks of trading futures. I'm saying that a commodity has price risk that is inherent in and of itself. If this were not so then futures markets would be unnecessary. The price risk inherent in a commodity is due to factors beyond human control: wars, civil unrest, weather, government policies, etc. - all which affect supply and demand. This is a simple fact that must be accepted and understood. No person puts the risk there, it already exists.
Understanding this will help you understand the purpose of speculators.
Hedgers trade futures contracts in order to mitigate prisk risk. Their primary goal in trading futures is not to earn a profit, but to protect themselves against the unpredictability of price changes. Hedgers are usually businesses that produce or use a particular commodity in their core business operations.
When a business hedges against the price risk associated with a particular commodity they can budget their operations effectively and carry out their core business with a measure of safety and predictability. These businesses, which are exposed to price risk in the cash market, can take an opposite position in the futures markets to transfer that risk to speculators. Essentially, hedging is a form of insurance.
For example, a business that uses copper in its manufacturing operations might worry about rising prices. In order to budget its operating costs for this necessary commodity, the company could buy a futures contract. If the price of copper in the cash market rises, the futures price would also rise and the profits from the futures market position would offset the increased expense of purchasing copper in the cash market. But, if the price of copper in the cash market falls, they would lose money in the futures markets, but their operating expenses would also decline because it would be cheaper to buy copper in the cash market. In other words, their position in the futures markets cancels any rise or fall of prices in the cash market.
The same is true for someone that produces or owns a physical commodity. For instance, if a wheat farmer seeks to sell the wheat he has planted in the ground, he might worry about declining prices affecting his bottom line. However, if he also sells wheat futures contracts he is able to protect himself. But, if prices decline and he cannot get a good price for his forthcoming wheat acerage in the cash market, the profit from his futures market position offsets this. Likewise, if wheat prices in the cash market rise he would lose on his futures market position, but he would get a better price from selling his wheat crop in the cash market.
Yet, hedgers would not be able to do any of this without speculators....
Speculators trade futures with one purpose in mind: to profit from price fluctuations. The formula is simple: if he buys a contract and the price rises he will realize a profit when he sells (offsets) that contract. The same is true if he sells a contract and the price declines. The misinformed often deride speculators as greedy people whose trading activities cause severe price fluctuations in the underlying commodities - thus negatively affecting consumer prices.
But, futures markets can not operate without speculators. Remember that price risk is inherent in a commodity; nobody puts the risk there. So, someone at some point has to shoulder this risk. Hedgers want to offset this risk so that they can control their operating expenses and speculators willingly take on this risk in the hopes of profiting.
If speculators didn't take the risk then the hedgers, and thus the end consumers of their commodities, would be faced with wildly unstable prices. Simply put, despite the speculator's desire for profit, they perform an essential economic function. This is the reason that futures markets are often described as a vehicle for "risk transference".
Speculators also perform another corollary function - they provide liquidity. The vast majority of trading volume is done by speculators. This allows hedgers to easily and quickly sell or buy contracts as needed. Because of speculators there is a buyer for every seller and a seller for every buyter. High trading volume also equates into efficient price discovery, which allows everyone throughout the world to easily see what is deemed a fair market price at any given point in time.
In conclusion, I should mention another important fact. The vast majority of futures contracts are not held into the delivery period. Approximately 95% of futures contracts are offset before the delivery period. This means that most buyers and sellers of these contracts do not intend to actually deliver or take delivery of the underlying commodity. Instead, they simply use the futures markets as insurance against price fluctuations or to seek profit from price fluctuations.