Hedgers are not primarily motivated by profit but by the need to manage risk related to their business or investment portfolio.
1. Speculators
These are futures traders who aim to profit from price moves, betting that price will move in a direction favorable to their trades. Speculators do not intend to take delivery of the physical goods, if any are involved in the first place. Futures speculation adds greater liquidity to the market since more parties are buying and selling.
While they don’t make up most futures traders, many protections in the market guard against speculators profiteering or causing volatility that would affect everyday consumers and other industries.
For example, speculation in futures markets for agricultural commodities like wheat, corn, and soybeans has been linked to significant price swings. The 2007–2008 global food crisis is a textbook example, given the dramatic increases in the prices of these staples at the time, with weather conditions and biofuel demand initially thought to be the cause. Ultimately, speculative trades took more of the blame for the price increases that hit consumers just as the financial crisis of that year was about to wreak widespread havoc.
A look at how it happened shows that hedging can turn into speculation, which can cause a major jump in prices. In early 2007, wheat prices began to climb because of bad weather conditions in key producing regions (e.g., Australia had a drought) and increased demand for grain used for food and biofuel. These problems were worsened by the lowest global wheat stockpiles in decades. Soon, there was a sharp rise in wheat futures prices, reaching record highs.
In February 2008, the price for wheat futures on the Chicago Board of Trade surged to over $13 per bushel from around $4 to $5 per bushel in the preceding years.
This spike in wheat prices had consequences worldwide: Traders bought up contracts, speculating on future price gains, and suppliers and manufacturers, anticipating higher future costs, raised prices preemptively, directly affecting consumer prices for wheat and related products. This increased the cost of bread and other wheat-based products, posing severe challenges to food security for billions around the globe.
2. Types of Futures Traders
The futures market has diverse participants, each with distinct strategies, objectives, and roles. Among these are hedge funds, individual traders, and market makers, who collectively contribute to the liquidity, depth, and efficiency of the market.
3. Hedge Funds
Hedge funds are managed pools of capital with wide latitude in generating returns for their investors. In the futures market, they may participate as speculators, leveraging their substantial capital to bet on the direction of commodity prices, interest rates, indexes, and other assets. Hedge funds often employ sophisticated trading strategies, including long and short positions, to capitalize on predicted market moves. Their activities can significantly influence prices because of the large volumes of trades they execute.
4. Individual Traders
Individual traders trade futures contracts for their own accounts. They might speculate on price moves to profit from short-term fluctuations or hedge personal investments in other markets. Individual traders have different strategies, risk tolerance, and amounts of capital at stake. With the advent of electronic trading platforms, individual traders have easier access to futures markets, allowing them to participate alongside institutional investors.
5. Institutional Investors
Institutional investors include professional asset managers, pension funds, insurance companies, mutual funds, and endowments. They invest large sums of money in financial instruments, including futures contracts, on behalf of their stakeholders or beneficiaries. In the futures market, institutional investors may engage in hedging to protect their portfolios from adverse market moves or speculate on future price directions to enhance returns. Given the large volume of assets under management, institutional investors can significantly affect market prices through their trading activities.
6. Market Makers
Market makers provide market liquidity by staying ready to buy and sell futures contracts at publicly quoted prices. They profit from the spread between the buying and selling prices. By continually offering to buy and sell contracts, market makers help ensure enough volume for trades to be executed promptly, reducing market volatility and making it easier for investors to enter and exit their positions.
7. Proprietary Trading Firms
Proprietary trading firms trade their own capital, not that of clients. These firms are in the business of making speculative trades to benefit directly from market moves. Proprietary trading firms may employ high-frequency trading, arbitrage, and swing trading (entering trades at or near the end of a downward movement and exiting at a near-peak in an upward movement, or vice versa for short positions) to generate profits. They are significant players in the market because of their aggressive trading tactics, sophisticated technology, and ability to take on substantial risks. Unlike hedge funds, proprietary trading firms invest their own funds rather than manage external capital, which can lead to different risk management strategies.
What’s Traded in the Futures Market?
The range of assets underlying futures covers everything from agricultural products to financial indexes. As of early 2024, the most traded futures were in equities (65% of futures trading by volume), currencies (9%), interest rates (9%), energy (5%), agriculture (4%), and metals (4%).
These futures allow traders to speculate on future crypto price moves without having to hold the digital assets. Given the extreme volatility in cryptocurrency markets, futures allow investors to hedge their digital asset portfolios or speculate on price changes without the security issues and other hassles of holding crypto directly.
7. Currencies
Currency or forex trading involves making money or hedging risk in foreign exchange rate changes. A wide variety of currency futures contracts are available. Aside from popular contracts such as euro/U.S. dollar currency futures, there are also e-Micro Forex Futures contracts that trade at one-10th the size of regular currency futures contracts.
One strategy that speculators use to trade currencies is scalping, which tries to make short-term profits from incremental changes in the value of a currency. Doing this repeatedly means that your earnings could add up over time. In general, your time frame can be as short as one minute or may last several days. A scalping strategy requires strict discipline to continue making small, short-term profits while avoiding significant losses.
Currency futures should not be confused with spot forex trading, which is more prevalent among individual traders.
Energy Prices
Geopolitical events, supply disruptions, and changes in demand because of economic growth can significantly impact energy prices. As such, energy futures are among the most vital parts of the commodities market, including crude oil, natural gas, gasoline, and heating oil. These contracts are crucial for energy producers and consumers to hedge against the volatile nature of energy prices. Downstream, the use of them by utilities could mean more affordable prices for people heating their homes.
8. Indexes
Introduced in 1982 by the Chicago Mercantile Exchange with futures for the S&P 500, index futures, such as the e-mini S&P 500 index futures contract, are among the most popular for individual investors, with event futures featuring wagering yes or no on specific occurrences often tied to indexes as well.
Index futures are a way to gain exposure to an entire index in a single contract. The Financial Industry Regulatory Authority requires a minimum of 25% of the total trade value as the minimum account balance.
However, some brokerages will demand greater than this 25% margin.
Index futures are available for the Dow Jones Industrial Average and the Nasdaq 100, as well as their respective fractional value versions, e-mini Dow and e-mini Nasdaq 100 contracts. Index futures are also available for foreign markets, including the Frankfurt Exchange and the Hang Seng Index in Hong Kong.
9. Interest Rates
Interest rate futures are financial derivatives that allow investors to speculate on or hedge against future changes in interest rates. These futures include those for Treasury bills, notes, and bonds, as well as on interest rate benchmarks. Treasury futures allow investors to speculate on or hedge against changes in interest rates, which affect the value of Treasury securities. For example, T-note futures are widely used to hedge against fluctuations in 10-year Treasury note yields, which are benchmarks for mortgage and other important financial rates.
More generally, bond futures are contracts to buy or sell a specific bond at a predetermined price on a future date. Investors use these to hedge against or speculate on changes in bond prices, which inversely correlate with interest rates. As interest rates rise, bond prices typically fall, and vice versa. Investors, fund managers, and financial institutions use bond futures to protect their portfolios against interest rate changes or to take positions based on their interest rate outlook.
10. Metal Prices
Metals, including gold, silver, copper, and platinum, have futures that trade extensively. These contracts are used by miners, manufacturers, and investors to hedge against price volatility. Precious metals like gold and silver are often considered safe havens during times of economic uncertainty, while industrial metals like copper are sensitive to economic growth and industrial demand since they are essential in electronics and construction. Futures trading in metals enables price discovery and risk management, providing a way to lock in prices for future delivery or a cash substitute.
What Is the Difference Between Futures and Options Trading?
Futures and options are derivatives, financial instruments derived from the value of underlying assets like commodities, currencies, or indexes. The key difference lies in the obligations they impose on buyers and sellers.
A futures contract is an agreement to buy or sell the underlying asset at a predetermined price on a specific future date, committing both parties to fulfill the contract at maturity. By contrast, an option gives the buyer the right, but not the obligation, to buy (the call option) or sell (the put option) the underlying asset at a set price before the option expires.
This difference means that options offer a way to hedge against risk or speculate with a lower upfront investment compared with futures, where the potential for both gain and loss can be more significant because of the obligation to execute the contract.
What Are Event Futures?
Unlike traditional futures contracts, which are based on the price changes of physical commodities or financial instruments, event futures are based on the occurrence of particular events.
These events can range from elections to changes in indexes and commodities prices. An event futures contract has a binary outcome: It settles at a predefined value if the event occurs (or a specific outcome is achieved) and settles at zero if the event doesn’t happen.
How Does Leverage Work in Futures Trading?
Leverage allows traders to control a large amount of the underlying asset with a relatively small amount of capital, known as margin.
In futures contracts, leverage is used to amplify the potential returns from changes in the price of the underlying asset. It is a double-edged sword that can significantly increase potential profits and potential losses. When traders enter a futures contract, they must deposit a fraction of the contract’s total value, typically 5% to 15%, with their broker. This is known as the initial margin. Because traders only put down a fraction of the total value, they can gain exposure to a large position without committing the total amount of capital upfront.
However, leverage also increases risk. If the market moves against the position, traders could face margin calls, requiring more funds to be deposited. If these margin requirements are not met, then the position may be closed at a loss. Therefore, while leverage can magnify gains, it can also magnify losses, sometimes exceeding the initial investment.
The Bottom Line
Futures trading allows investors to lock in prices for commodities, currencies, and financial instruments months or even years in advance, providing a critical tool for managing price risk and speculation. While futures were limited to commodities when first introduced, they now cover a wide range of events and market moves, enabling investors to hedge against unfavorable market shifts or the chance to profit from price volatility without requiring the physical exchange of the underlying asset.
Traders should carefully consider their risk tolerance and engage in futures judiciously, employing risk management strategies such as stop-loss orders to protect against significant losses.
SPONSORED
Trade on the Go. Anywhere, Anytime
One of the world’s largest crypto-asset exchanges is ready for you. Enjoy competitive fees and dedicated customer support while trading securely. You’ll also have access to Binance tools that make it easier than e er to view your trade history, manage auto-investments, view price charts, and make conversions with zero fees. Make an account for free and join millions of traders and investors on the global crypto market