Hedgers
The details of hedging can be somewhat complex but the principle is
simple. Hedgers are individuals and firms that make purchases and sales
in the futures market solely for the purpose of establishing a known
price level--weeks or months in advance--for something they later
intend to buy or sell in the cash market (such as at a grain elevator
or in the bond market). In this way they attempt to protect themselves
against the risk of an unfavorable price change in the interim. Or
hedgers may use futures to lock in an acceptable margin between their
purchase cost and their selling price. Consider this example:
A jewelry manufacturer will need to buy
additional gold from his supplier in six months. Between now and then,
however, he fears the price of gold may increase. That could be a
problem because he has already published his catalog for a year ahead.
To lock in the price level at which gold is
presently being quoted for delivery in six months, he buys a futures
contract at a price of, say, $350 an ounce.
If, six months later, the cash market price
of gold has risen to $370, he will have to pay his supplier that amount
to acquire gold. However, the extra $20 an ounce cost will be offset by
a $20 an ounce profit when the futures contract bought at $350 is sold
for $370. In effect, the hedge provided insurance against an increase
in the price of gold. It locked in a net cost of $350, regardless of
what happened to the cash market price of gold. Had the price of gold
declined instead of risen, he would have incurred a loss on his futures
position but this would have been offset by the lower cost of acquiring
gold in the cash market.
The number and variety of hedging
possibilities is practically limitless. A cattle feeder can hedge
against a decline in livestock prices and a meat packer or supermarket
chain can hedge against an increase in livestock prices. Borrowers can
hedge against higher interest rates, and lenders against lower interest
rates. Investors can hedge against an overall decline in stock prices,
and those who anticipate having money to invest can hedge against an
increase in the over-all level of stock prices. And the list goes on.
Whatever the hedging strategy, the common
denominator is that hedgers willingly give up the opportunity to
benefit from favorable price changes in order to achieve protection
against unfavorable price changes.
Speculators
Were you to speculate in futures contracts, the person taking the
opposite side of your trade on any given occasion could be a hedger or
it might well be another speculator--someone whose opinion about the
probable direction of prices differs from your own.
The arithmetic of speculation in futures
contracts--including the opportunities it offers and the risks it
involves--will be discussed in detail later on. For now, suffice it to
say that speculators are individuals and firms who seek to profit from
anticipated increases or decreases in futures prices. In so doing, they
help provide the risk capital needed to facilitate hedging.
Someone who expects a futures price to
increase would purchase futures contracts in the hope of later being
able to sell them at a higher price. This is known as "going long."
Conversely, someone who expects a futures price to decline would sell
futures contracts in the hope of later being able to buy back identical
and offsetting contracts at a lower price. The practice of selling
futures contracts in anticipation of lower prices is known as "going
short." One of the attractive features of futures trading is that it is
equally easy to profit from declining prices (by selling) as it is to
profit from rising prices (by buying).
|