Futures markets exist for the purposes of price discovery (facilitation of trade) and transferring risk to counterparties (hedgers trading with speculators). The optimal condition for this price discovery is having a central Exchange where buyers and sellers can meet in a price competitive environment. These Exchanges also create contract specifications and create rules that are available to all traders before they place any trades. This way everybody is aware of exactly what price points and quality of the Commodity they are trading will be in advance of any transaction.
There are many different Futures markets, but I will be using the Wheat market for this particular article. Any Futures trader with a trading account at a Futures Commission Merchant (FCM) may participate in this daily price discovery process. Any trader who does not use the Wheat product in their daily business will be classified as a non-commercial large or small speculative trader. Market participants that actively use Wheat are classified as a Commercial or Hedger participant. Commercial traders usually have Futures positions opposite of their Cash position. Producers of Commodity products are usually short Futures contracts. Processors of Commodity products are usually long Futures contracts. A Commercial traders objective is not to speculate, but to merely offset price risk to lock in a profit margin. Speculators on the other hand are looking to anticipate the market’s direction and bet whether the market will rise or fall.
A Futures participant can also use Options to speculate or hedge with. If you believe Wheat will rise you can purchase a Call Option or Sell a Put Option. If you believe prices will fall you can purchase a Put Option or sell a Call Option. A long Call (Put) Option is the right, but not the obligation, to go long (short) the underlying Future contract at the Strike price at or before expiration. A short Call (Put) Option is the obligation to deliver (take delivery of ) the underlying Future at or by the expiration if that Option is exercised.
Commercials / Hedgers often use Wheat Options. Producers of Wheat can set a floor beneath a selling price with long Put Options. Processors can set a ceiling above their costs to process with long Call Options. Obviously there are many other sophisticated ways of using Options strategies that are available to all market participants.
The cost to do business in the Futures markets is minimal. For each Futures contract a Speculator or Hedger uses they will post an initial margin amount for the first trading day they carry the position over from a day trade. These margins are set and monitored by each Futures Exchange that… Continue Reading
