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A Guide to Understanding Opportunities and Risks in Futures Trading

from The National Futures Association

The Market Participants

Should you decide to trade in futures contracts or options, either for speculation or price risk management, your orders to buy or sell will be communicated through your brokerage firm to the trading floor for execution by a floor broker. If you are a buyer, the broker will seek a seller at the lowest available price. If you are a seller, the broker will seek a buyer at the highest available price. That’s what the shouting and signaling is about. Electronic systems are designed to achieve the same outcome.

Whatever the method of trading, the person who takes the other side of your trade may be or may represent someone who is a commercial hedger or perhaps someone who is a public speculator. Or, quite possibly the other party may be an independent trader who is trading for his own account. In becoming acquainted with futures markets, it is useful to have at least a general understanding of who these various market participants are, what they are doing and why.

Hedgers

The details of hedging can be somewhat complex but the principle is simple. By buying or selling in the futures market now, individuals and firms are able to establish a known price level for something they intend to buy or sell later in the cash market. Buyers are thus able to protect themselves against — that is, hedge against — higher prices and sellers are able to hedge against lower prices. Hedgers can also 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 its supplier in six months to produce jewelry that it is already offering in its catalog at a published price. An increase in the cost of gold could reduce or wipe out any profit margin. To minimize this risk, the manufacturer buys futures contracts for delivery of gold in six months at a price of $300 an ounce.

If, six months later, the cash market price of gold has risen to $320, the manufacturer will have to pay that amount to its supplier to acquire gold. But the $20 an ounce price increase will be offset by a $20 an ounce profit if the futures contract bought at a price of $300 is sold for $320.

The hedge, in affect, provided protection against an increase in the cost of gold. It locked in a cost of $300, regardless of what happened to the cash market price. Had the price of gold declined, the hedger would have incurred a loss on the 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 corporate treasurer who will need to borrow money at some future date can hedge against the possibility of rising interest rates. An investor can use stock index futures to hedge against an overall increase in stock prices if he anticipates buying stocks at some future time or against declining stock prices if he or anticipates selling stocks. A cattle feeder can hedge against lower livestock prices and a meat packer against higher livestock prices. An exporter who has contracted to ship commodities on a future date at a fixed price can hedge to lock in the cost of acquiring the commodities for shipment, much as the jewelry manufacturer did.

Whatever the hedging strategy, the common denominator is that hedgers are willing to 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 by buying to profit from a price increase or selling to profit from a price decrease, the party taking the opposite side of your trade on any given occasion could possibly be a hedger or it might be another speculator, someone whose opinion about the probable direction and timing of prices differs from your own.

The arithmetic of speculation in futures contracts, including the opportunities it offers and the equally important risks it involves, will be discussed in detail later on. For now, suffice it to say that speculators put their money at risk in the hope of profiting from an anticipated price change.

Buying futures contracts with the hope of later being able to sell them at a higher price is known as "going long." Conversely, selling futures contracts with the hope of being able to buy back identical and offsetting futures contracts at a lower price is known as "going short." An attraction of futures trading is that it is equally as easy to profit from declining prices (by selling) as it is to profit from rising prices (by buying).

  Reasons for BUYING futures contracts Reasons for SELLING futures contracts
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.
Speculators: To profit from rising prices. To profit from declining prices.

Next chapter: What is a Futures Contract?


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