The futures markets came into existence for the purpose of hedging future prices of commodities and other goods. The number of available futures contracts has grown to cover almost any financial transaction a producer, buyer or money manager might want to hedge. Speculators are the grease which make hedging wheels turn smoothly.
A futures contract is a standardized contract for the future delivery of a specific amount of a particular commodity or financial instrument. A buyer of a futures contract locks in today's price for delivery at the future date specified. The seller locks in his selling price. A list of the futures categories from the CME Group shows the wide range of available futures: Agriculture, energy, equity index, FX, interest rates, metals, weather and real estate.This range of available futures gives both those hedging positions and speculators many tools from which to choose.
The futures markets provide a high level of liquidity and trading volume compared to other derivative products. For agricultural products, futures trading is the only option for hedging besides illiquid private forward contracts. For equity and interest rate products, the trading volume of futures has grown much faster than alternative ways to hedge or speculate. Higher trading volumes mean it is easier to get a hedging or trading position filled at a lower spread or cost.
Hedging is like buying insurance against the potential of decreased market value of investments or commodities you own. An investment manager with a $10 million portfolio can sell stock index futures which will go up in value if the stock market declines, protecting the value of his portfolio. Hedging with futures allows a high level of flexibility with regard to how the hedge will perform if the market moves in a certain direction.
Hedgers using futures do so to prevent losses or lock in prices and eliminate uncertainty. Speculators often take the opposite side of a futures trade to assume the risk the hedger is trying to protect against. Futures trading provides a high level of leverage, allowing speculators to put up a relatively small amount of money to take a large position in the underlying instrument. The margin requirements of futures allow speculators to leverage their trading money 10 to 20 times, depending on specific futures contracts. Futures trading also allows tradings for profits in either direction, up or down, with the same products and costs.
- Jupiterimages/Comstock/Getty Images