When you look at futures trading, it may appear that there is a never-ending tug of war between the profit-seeking speculators and the ever-so-careful hedgers. Actually, the two factions are the ultimate odd couple: They cannot live without each other, even though they each pursue markedly different objectives.
In short, hedgers and speculators both help support the orderly functioning of the futures markets. That’s because both sides are necessary to keep the cash flowing, which helps commodities or other instruments discover their true market value.
For many people, the term “speculator” has a negative connotation. The great Henry Ford once sniffed: “Speculation is only a word covering the making of money out of the manipulation of prices, instead of supplying goods and services.” However, market critics sometimes confuse, or lump together, people who are making legal investments to turn a profit with schemers trying to manipulate markets illegally.
Speculators are attracted to market volatility, which helps them earn a return — either on the upside or the downside of a trade. However, because speculators invest funds in the market, usually for the shorter term, the broader market benefits because their trading brings greater clarity to the value of the underlying asset.
Imagine if the grain markets consisted only of the farmers on the one side and consumers and agribusinesses on the other. Low-volume trading would beleaguer that market, and it would not be hard to imagine a larger entity manipulating prices to its advantage. However, a self-interested speculator stepping in adds a little more grease to the wheels of trading because all sides benefit in the longer run with a greater number of players.
Hedging originated in farming and the grains, evolving most famously from Chicago’s historic markets, but it now extends to currencies, interest rates and stock indices. Hedgers are not out to make a quick buck. They need to protect a position, by purchasing some insurance for an underlying asset they currently own. Hedgers buy a futures contract to lock in a price as protection.
Hedging is about taking an opposite position in the market, with the aim of protecting against future volatility. For example, airlines turn to hedging to manage their biggest cost drain: fuel. Airline stocks often gyrate with the speculative nature of oil markets. Low-cost airlines are typically most active in hedging because they are highly exposed to the cost of fuel.
Fuel hedging is also common across the trucking and shipping sectors. Companies that deal in gold, such as large jewelers, may also buy a futures contract to protect them against volatility if they have a big order on the books that involves a large supply of the precious metal.
Hedging is not foolproof, however, because hedgers may incur hedging costs and losses when they bet the wrong way. In the long run, however, profit margins are better protected when hedgers participate in effectual futures markets.
Opposites Attract in the Futures Markets
To sum up, hedgers are risk averse because they are trying to protect a position — something that could affect the bottom line of their farm or business. However, how would hedgers ever find the value of a commodity if it is dominated by their fellow hedgers? That is where the speculators come in. They provide the needed counterbalance to hedgers.