The futures market (part 10)

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Forward and futures contract (part 10)

Futures is for hedging and options are for speculators.

Since I have been discussing Futures in my previous editorials, I suggest let us see the difference between the hedgers and the speculators who may trade different instruments.

Hedgers may be farmers or commodity suppliers (mining companies) and may hedge using futures or forward contract by taking an offsetting position to lock in profit from the underlying asset.

Hedgers attempt to reduce the risk if the price of their crop or commodity is likely to be volatile in the coming months. Hedging attempts to eliminate the volatility.

Speculators on the other hand attempt to profit from betting on an outcome.  They gamble that certain price will move as they predicted.

Hedgers eliminate the risk by the fact that they take an opposite side so a loss on one asset can become a profit in the other instrument so that one cancels the other.  For example, assume that a small gold miner has a major contract due in six months, for which gold is one of the company’s main inputs. The company is worried about the volatility of the gold market and believes that gold prices may drop substantially in the near future. In order to protect itself from this uncertainty, the company could sell a six-month futures contract in gold. This way, if gold experiences a 10% price drop, the futures contract will lock in a price that will offset this loss. As you can see, although hedgers are protected from any losses, they are also restricted from any gains..

Speculators make bets or guesses on where they believe the market is headed. For example, if a speculator believes that a stock is overpriced, he or she may short sell the stock and wait for the price of the stock to decline, at which point he or she will buy back the stock and receive a profit. Speculators are vulnerable to both the downside and upside of the market; therefore, speculation can be extremely risky.

Overall, hedgers are seen as risk averse and speculators are typically seen as risk lovers. Hedgers try to reduce the risks associated with uncertainty, while speculators bet against the movements of the market to try to profit from fluctuations in the price of securities.