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Speculating & Hedging

 

Speculators are people who analyze and forecast futures price movement and trade contracts with the hope of making a profit. Speculators put their money at risk and must be prepared to accept outright losses in the futures market.


How do speculators profit?


Speculators earn a profit when they offset futures contracts to their benefit. To do this, a speculator buys contracts then sells them back at a higher (contract) price than that at which they purchased them. Conversely, they sell contracts and buy them back at a lower (contract) price than they sold them. In either case, if successful, a profit is made.


Are there different kinds of speculators?


Often times, speculators specialize in particular commodities. If the speculator is a CME member, you’ll find them in their favorite trading pits at the exchange. For example, a private speculator may specialize in Eurodollars and trade only in the Eurodollar pit day after day. Each speculator will trade according to his or her own style. Some traders are scalpers who buy and sell futures contracts quickly when prices move only a fraction of a cent. Others are day traders who will buy and sell throughout the day, closing their position before the session ends. Others are position traders who may hold their positions for days, weeks or months at a time.

Of course, speculators don’t have to be CME members. There are thousands of individuals who trade speculatively through brokerage firms.


The Role of the Speculator


Speculators enter the futures market when they anticipate prices are going to change. While they put their money at risk, they won’t do so without first trying to determine to the best of their ability whether prices are moving up or down.



Speculators analyze the market and forecast futures price movement as best they can. They may engage in the study of the external events that affect price movement or apply historical price movement patterns to the current market. In any case, the smart speculator doesn’t operate blind.

A speculator who anticipates upward price movement would want to take advantage by buying futures contracts. If predictions are correct, then the contracts can be sold later at a profit. If it’s expected that prices were going to move downward, the speculator would want to sell now and, if all goes as planned, buy back later at a lower price.


Hedger vs. Speculator


All the people who trade futures contracts are not speculators. People who buy and sell the actual commodities can use the futures markets to protect themselves from commodity prices that move against them. They’re called hedgers.


The Hedgers


There’s a futures contract for a commodity or financial product because there are people who conduct an active business in that commodity. For example, there’s a Lumber futures contract because there are lumber producers who sell lumber and companies that buy lumber. The hedger plans to buy (sell) a commodity, such as lumber or live cattle, and buys (sells) a futures contract to lock in a price and protect against rising (falling) prices. The need for risk management that futures can meet holds true for all markets, including financial markets. Internationally, companies hedge their foreign exchange and interest rate exposures. Similarly, portfolio managers hedge stock fund risk.


Hedging

Producers and users of commodities who use the futures market are called hedgers. Buying and selling of futures for risk management is called hedging. Commodity prices in the cash markets have a fundamental relationship to the futures prices. When the forces of supply and demand shift and drive prices up and down in the cash markets, futures prices tend to rise and fall in a parallel fashion. So, for example, if cattle prices in the cash markets started to rise, the live cattle futures should start to rise in roughly the same way. They don’t tend to move in exact amounts. Hedgers take advantage of this relationship between cash and futures prices.


Hedging is buying or selling futures contracts as a temporary substitute for buying or selling the commodity at a later date in the cash market. We’ll show how that works. Here’s how hedging works. Let’s take a look at the meat packer. Suppose a meat packer needs to buy cattle in October. Today’s cash price is okay, but what if prices rise? The meat packer can lock in a price on the cattle today, just in case the cash prices do go up between now and October. Buying October Live Cattle futures contracts can protect an October purchase price. This is called a long hedge.


Who are hedgers?


Well, you know about lumber producers and meat packers. Others are commercial firms or individuals whose businesses concern the same or similar commodities that are traded on the futures markets. They’re both U.S. and international firms, including banks, corporations, pension funds, exporters and importers who need to protect against foreign currency fluctuation, food processors and a great variety of other businesses.

 

The Short Hedge

In a short hedging program, futures are sold. Traders who either own the underlying commodity or are in some way subject to losses if its price declines use this strategy.

 

The Long Hedge

Suppose the miller knows in July that in September he will buy 10,000 bushels of wheat from a grain elevator operator for grinding into flour. He worries that wheat prices will rise in the meantime because he has already guaranteed a price at which to sell flour to a baker in October. Because he does not have the wheat now, he is considered to be "short the actual" or "short the cash market."Therefore, to hedge this risk in the futures market, he can buy two wheat futures contracts (each represents 5.000 bushels). In September the cash price of wheat rises, the value of his futures contracts will rise too. The profit on the futures "leg" of his hedge will be earned by selling the futures at a higher price than he paid when he initiated the position, and will offset the extra money he must pay the grain elevator operator for the wheat.

 
 
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