Hedgers vs. speculators
Every futures trade has a buyer and a seller. But why are they there in the first place? Regulators and exchanges sort the people in the futures market into two big groups: hedgers and speculators. Knowing the difference tells you who you are trading against, and who you are about to become.
Hedgers: people protecting a business
A hedger has a real business that is exposed to price changes. They use futures to reduce risk, not to make a bet.
Remember the farmer from Lesson 1. She is worried that the price of her crop will fall before harvest. She can sell a futures contract in the spring. If the price drops by fall, she gets less for her crop at the local market, but her futures position gains, and the gain helps make up the difference. If the price rises instead, her futures position loses, but she sells her crop for more. Either way, she has locked in something close to the price she planned on.
Hedgers come in a few flavors:
- Sellers worried about falling prices, like the farmer or a steel mill.
- Buyers worried about rising prices, like the baker, a construction company buying steel, or an airline buying fuel.
- Merchants who both buy and sell goods and care about the gap between the two prices.
Hedging is not only for physical goods. A manager running a large stock portfolio can sell stock index futures to protect against a market drop without selling the stocks themselves.
Speculators: people accepting risk to seek a profit
A speculator has no business to protect. They trade futures because they want to profit from price changes. A speculator who expects prices to rise buys. One who expects prices to fall can sell first and buy back later, hopefully at a lower price. (You will learn exactly how that works in Lesson 11.)
Speculators include:
- Individual traders using their own money
- Proprietary trading firms (“prop firms”) that trade the firm’s capital
- Fund and portfolio managers
- Hedge funds
- Market makers, firms that agree to keep bids and offers in the market
Why the market needs both
Hedgers want to hand off risk. Somebody has to take it. Speculators are willing to take that risk in exchange for the chance of a profit. All that buying and selling also creates liquidity, which means there is usually someone ready to trade with you at a fair price. That makes it easier for everyone, hedgers included, to get in and out.
Which one are you?
If you are taking this course to trade stock index futures with your own account, you are a speculator. That is not a bad word. It just means you are accepting risk in the hope of a reward, with no underlying business to protect.
That also means something important: every dollar you risk is real risk. The farmer’s futures loss is offset by her crop. Yours is not offset by anything. Regulators are blunt about this: speculating in futures is risky, and many people lose money. The rest of this course is built to help you understand that risk before you ever take it.
Key ideas
- Hedgers use futures to reduce price risk in a real business.
- Speculators accept risk in the hope of profiting from price changes.
- Speculators add liquidity, which helps everyone trade.
- As a self-directed trader, you are a speculator, and your losses are not offset by anything else.