All kinds of people come to futures exchanges, to buy and sell futures and options contracts. They may work for banks, corporations or governments. They may be livestock ranchers, investment managers, construction planners, farmers or food manufacturers. Really, futures trading involves just about anyone in the world who wants either to manage the risk of fluctuating prices or profit from those fluctuations. But whoever they are, and wherever they came from, these traders are interested in two types of trading: hedging and speculating.
Hedgers and speculators go hand in hand – if you took one away, there simply would be no market. Hedgers transfer risk, and speculators absorb that risk. It takes both types of traders to bring balance to the market and keep trades moving back and forth.
Meet the hedger
The hedger buys futures contracts because he wants to protect himself from price swings in the future. By using futures to lock in a future price for a product, he makes his costs – and his profits – more predictable. In other words, he trades futures to drive risk out of his business.
But that risk doesn’t just disappear into thin air – it gets transferred to the speculator.
Meet the speculator
The speculator accepts price risk in pursuit of profit. Speculators have no interest in owning the product being traded, but they are interested in the contracts for those products. Think of it like investing – buying and selling futures contracts in order to make a profit when prices move in the right direction.
Hedger or Speculator
People who trade futures contracts come to an exchange to hedge and speculate on the future prices of a wide range of products. Outside the exchanges, people hedge and speculate on all sorts of everyday financial matters. To better understand what these practices look like in the real world, take the quiz below.
What does hedging and speculating look like in everyday life? See if you can tell who's doing what.
The homeowner is speculating.
She is accepting real estate market risk in exchange for the opportunity to profit.
The retirement fund manager is speculating.
He is interacting with the markets in ways that may maximize his client's retirement fund.
The chocolate maker is hedging.
Whatever happens to next year's cocoa crop, the company has locked in a stable supply at a predictable price.
The chain store is speculating.
The company is putting down capital and resources with the intent to profit off its investments.
The steel distributor is hedging.
The factory is locking in profits by ensuring that they have the supply needed to meet impending demand.
The stock trader is speculating.
She believes the company is poised to grow and, when it does, her returns will exceed her initial investment.
The car collector is hedging.
He is protecting his investment by transferring risk to an insurance company willing to protect him from financial loss.
0 of 7 correct
These were just a few examples of how hedgers and speculators operate in everyday life. And you know what? Any of these hedgers could act as speculators, and vice versa – it just depends on how their needs align with their appetite for risk at any point in time.