4) Futures Fundamentals: The Players
Players are classified into two categories: hedgers and speculators.
A person who buys or sells in the futures market to secure the future price of a commodity with the intent of selling at a later date in the cash market is called a hedger. These include the farmers, manufacturers, importers, and exporters. This is important to help protect against price risks.
Those in the long position would want to secure as low a price as possible while those in the short position would want to secure a price as high as possible. The futures contract is the means that would provide a definite price certainty for both parties which decreases that risks associated with price volatility. Hedging by means of a futures contract can also be used as a way to set an agreeable price margin between the cost of raw materials and the cost of the final product.
Here is an example:
A silversmith must secure a certain amount of silver in six months time for earrings and bracelets that have already been advertised in an upcoming catalog with specific prices. But what if the price of silver goes up over the next six months? Because the prices of the earrings and bracelets are already set, the extra cost of the silver can’t be passed on to the retail buyer, meaning it would be passed on to the silversmith. The silversmith needs to hedge, or minimize her risk against a possible price increase in silver. How?
The silversmith would enter the futures market and purchase a silver contract for settlement in six months time (let’s say June) at a price of $5 per ounce. At the end of the six months, the price of silver in the cash market is actually $6 per ounce, so the silversmith benefits from the futures contract and escapes the higher price. Had the price of silver declined in the cash market, the silversmith would, in the end, have been better off without the futures contract. At the same time, however, because the silver market is very volatile, the silver maker was still sheltering himself from risk by entering into the futures contract.
So that’s basically what hedging is: the attempt to minimize risk as much as possible by locking in prices for future purchases and sales. Someone going long in a securities future contract now can hedge against rising equity prices in three months. If at the time of the contract’s expiration the equity price has risen, the investor’s contract can be closed out at the higher price. The opposite could happen as well: a hedger could go short in a contract today to hedge against declining stock prices in the future.
A potato farmer would hedge against lower French fry prices, while a fast food chain would hedge against higher potato prices. A company in need of a loan in six months could hedge against rising interest rates in the future, while a coffee roaster could hedge against rising coffee bean prices next year.
There are some investors whose aim is not to reduce risk but to benefit from the risky nature of the futures market. These investors are called the speculators. They aim to profit from the price change that hedgers protect themselves from. Hedgers want to reduce risk at all times, but the speculators want to increase risk to max out their profits.
In the futures market, the speculator would be the one buying a contract low in order to sell it high in the future. He, most probably, would be buying from a hedger who is selling a contract at a low price in anticipation of a price decline.
The speculator does not enter the market with the objective to own the goods in question. Instead, the goal is to profit by offsetting rising and declining prices through the buying and selling of futures contracts.
Speculators and hedgers, in reality, benefit from each other. As the time of the contract’s expiration draws near, the information entering the market regarding the commodity in question will become more reliable. This enables everyone to expect a more precise reflection of supply and demand and the corresponding price.
An independent agency of the U.S. government, called the Commodity Futures Trading Commission (CFTC), regulates the U.S. futures market. The market is also subject to a self-regulatory body authorized by the U.S. Congress and subject to the CFTC supervision, called the National Futures Association (NFA).
In order to buy and sell futures contracts, a broker or a firm must be registered with the CFTC. In order to conduct business, brokers and firms must be registered with both CFTC and NFA. In cases of illegal activity, the CFTC has the right to seek criminal prosecution from the Department of Justice. Violations of the NFA’s business ethics and code of conduct can be grounds to permanently bar a company or person from dealing in the futures exchange. Investors who want to enter the futures market must, therefore, understand the regulations and make sure that brokers, traders, or companies acting on their behalf are duly licensed.
If unfortunately you suffer from conflict or illegal loss, you can ask the NFA for arbitration or appeal for repatriations from the CFTC.