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Hedgers
The details of hedging can be somewhat complex but the principle is simple.
Hedgers are individuals and firms that make purchases and sales in the futures
market solely for the purpose of establishing a known price level--weeks or
months in advance--for something they later intend to buy or sell in the cash
market (such as at a grain elevator or in the bond market). In this way they
attempt to protect themselves against the risk of an unfavorable price change in
the interim. Or hedgers may use futures to lock in an acceptable margin between
their purchase cost and their selling price. Consider this example:
A jewelry manufacturer will need to buy additional gold from his supplier in six
months. Between now and then, however, he fears the price of gold may increase.
That could be a problem because he has already published his catalog for a year
ahead.
To lock in the price level at which gold is presently being quoted for
delivery in six months, he buys a futures contract at a price of, say, $350 an
ounce.
If, six months later, the cash market price of gold has
risen to $370, he will have to pay his supplier that amount
to acquire gold. However, the extra $20 an ounce cost will
be offset by a $20 an ounce profit when the futures contract
bought at $350 is sold for $370. In effect, the hedge
provided insurance against an increase in the price of gold.
It locked in a net cost of $350, regardless of what happened
to the cash market price of gold. Had the price of gold
declined instead of risen, he would have incurred a loss on
his futures position but this would have been offset by the
lower cost of acquiring gold in the cash market.
The number and variety of hedging possibilities is practically limitless. A
cattle feeder can hedge against a decline in livestock prices and a meat packer
or supermarket chain can hedge against an increase in livestock prices.
Borrowers can hedge against higher interest rates, and lenders against lower
interest rates. Investors can hedge against an overall decline in stock prices,
and those who anticipate having money to invest can hedge against an increase in
the over-all level of stock prices. And the list goes on.
Whatever the hedging strategy, the common denominator is that hedgers willingly
give up the opportunity to benefit from favorable price changes in order to
achieve protection against unfavorable price changes.
Speculators
Were you to speculate in futures contracts, the person taking the opposite side
of your trade on any given occasion could be a hedger or it might well be
another speculator--someone whose opinion about the probable direction of prices
differs from your own.
The arithmetic of speculation in futures contracts--including the opportunities
it offers and the risks it involves--will be discussed in detail later on. For
now, suffice it to say that speculators are individuals and firms who seek to
profit from anticipated increases or decreases in futures prices. In so doing,
they help provide the risk capital needed to facilitate hedging.
Someone who expects a futures price to increase would purchase futures contracts
in the hope of later being able to sell them at a higher price. This is known as
"going long." Conversely, someone who expects a futures price to decline would
sell futures contracts in the hope of later being able to buy back identical and
offsetting contracts at a lower price. The practice of selling futures contracts
in anticipation of lower prices is known as "going short." One of the attractive
features of futures trading is that it is equally easy to profit from declining
prices (by selling) as it is to profit from rising prices (by buying).
Floor Traders
Persons known as floor traders or locals, who buy and sell for their own
accounts on the trading floors of the exchanges, are the least known and
understood of all futures market participants. Yet their role is an important
one. Like specialists and market makers at securities exchanges, they help to
provide market liquidity. If there isn't a hedger or another speculator who is
immediately willing to take the other side of your order at or near the going
price, the chances are there will be an independent floor trader who will do so,
in the hope of minutes or even seconds later being able to make an offsetting
trade at a small profit. In the grain markets, for example, there is frequently
only one-fourth of a cent a bushel difference between the prices at which a
floor trader buys and sells.
Floor traders, of course, have no guarantee they will realize a profit. They may
end up losing money on any given trade. Their presence, however, makes for more
liquid and competitive markets. It should be pointed out, however, that unlike
market makers or specialists, floor traders are not obligated to maintain a
liquid market or to take the opposite side of customer orders.
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Reasons for Buying
futures contracts
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Reasons for Selling
futures contracts
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Hedgers |
To lock
in a price and thereby obtain protection
against rising prices |
To lock
in a price and thereby obtain protection
against declining prices |
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Speculators and floor Traders |
To
profit from rising prices |
To
profit from declining prices |
Next:
What is a Futures Contract?
related topics:
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