The goals of futures market participants can be divided into two broad categories: hedging- seeking to reduce the risk associated with owning the underlying commodity or financial instrument; and speculating- seeking to profit from price changes in the futures markets. Both approaches contribute to fair and orderly markets.
Hedging / Price Protection
For investors who are exposed to the price fluctuation of a commodity or financial instrument, futures provide a way to manage this risk. By taking the opposite position in futures, investors can mitigate the adverse impact of movements against the value of their assets.
Example: An investor has a substantial broad-based stock portfolio. While he has concerns about how the release of upcoming economic news might affect the value of his positions, he is confident in their long-term prospects. However, in order to protect the value of his stocks from a possible decline, the investor sells S&P 500 futures. He is left with the following:
If the stock market at large falls after negative projections, the stock portfolio will lose money. The futures position, on the other hand, will profit. Conversely, if the broader market rises, any gains in the stock portfolio will be offset by a loss on the futures position. By taking a position in futures contracts, an investor can protect his portfolio from volatile price swings in the market.
In the hopes of making short-term profits, speculators assume the risk of price movements that hedgers seek to avoid. Speculators strive to profit from fluctuations by buying and selling futures contracts.
Since traders assume a short position in futures just as easily as a long position, speculators trade based upon their anticipation of the market's direction. Trading futures allows speculators to outlay less money than would be needed to purchase the underlying asset, usually between five and fifteen percent of its total value. As a result, speculators can control more of the underlying market and potentially achieve greater profits from price swings.
While offering the possibility of greater profits, this leverage can also work against the speculator by allowing losses greater than the initial margin deposited. If the price of a futures position goes against the speculator, the exchange may require a deposit of additional funds to maintain the position. If the price does not move in the direction the speculator desires, he or she may lose more than the initial investment.
In attempting to capitalize on price fluctuations, speculators provide market liquidity, which in turn lowers transaction costs by keeping the bid/offer spreads tight and providing reliable prices.