Hedgers and Speculators

Well, there is once again delay in posting here and it is for the same reasons which I explained on Options blog. Nevertheless we will try to make up for the lost time.

First let us try to understand meaning and functions of Hedgers and Speculators. In the classical futures market explained in the earlier post the role of the farmer and buyer would be that of a producer and trader. Every producer will like to make sure that there is no price risk for his products in the future. Similarly trader (who can be again a manufacturer for something else using product of first manufacturer as raw material) would also like to make sure that there is no price risk for the items he/she wants to buy. So producer hedges his position against a possible drop in price by entering in to a futures contract while trader hedges his position against a possible rise in the input cost. Both of them want to sleep well without worrying about volatility and making sure that they know the price they will get or pay for the particular underlying. In short, they want to cut their risk i.e. nothing but they want to hedge their positions. They are hedgers.

On the other hand, speculators want to make use of this inherent risk (that is always present) in the futures market to make money. These guys are (most of the time) neither producers nor traders and in fact have nothing to do with the underlying. All they are interested in making some money betting against the producers and/or traders for a short duration. When speculators buy a position hoping that price would increase they are usually buying it from hedgers who wants to cut downside risk of their produce.

As I said in previous post too, this is not necessarily a bad thing. In fact, it is these guys who have made futures market one of the largest traded markets in the world and they help it in many ways. These guys want to remain updated of all current and likely events in the immediate future and factor in developments in every thing like RBI meet, FED meet, Euro Zone meet, Tsunamis and what not in to the price of the contract. This act of them helps a lot in real Price Discovery of the underlying.

Another important advantage of futures market is Risk Reduction. Hedgers try to secure a price for their product (as a producer or as a buyer) and know their margins beforehand. This provides a lot of stability to the general business environment.

In the next post, which I promise won't be far, we will talk about settlements of Future contracts.