A lot of times when people think about futures markets, they imagine the fast paced locals shouting bids and offers across an open outcry pit while waving hand signals and throwing paper around, all the while trying to make a living off of the markets. This is the legendary, yet controversial image of the commodities trader. Although this depiction may be a little dramatic, the portrayal is fairly accurate. Not everybody trading wheat fits this mold, but many do. These locals are called speculators. Speculators are made up of the independent floor traders and everyone else who uses financial market for reasons other than commercial or industrial purposes.
Speculators are often blamed for market turmoil, but this should be ignored. Yes, the big speculators do have the power through leverage to sometimes push a market away from equilibrium. Most of the individuals trading wheat markets for speculative purposes are either trying to make an honest living or want to grow their capital through other means than a 401k and mutual funds. These people play a vital role in the market place by providing liquidity. Liquid futures markets are necessary for commercial interests to conduct their business.
Those who use the market for means other than speculation are the commercial and industrial interests. Unlike the speculators who, by trading wheat markets, take on risk, the commercials use the wheat market for reducing risks. These market players use futures contracts because of the underlying risks associated with exposure to wheat prices. This brings up another point. Speculators rarely use cash markets for trading wheat purposes because of the costs associated with transportation and storage. Hedgers use the cash market alongside the futures markets. For example, farmers with a crop in the ground have a perceived interest in seeing the price of wheat rise before harvest. They are essentially holding a long market position relative to the size of their crop. A flour miller on the other hand has to secure wheat as an input cost. The miller has an interest in seeing the price of wheat drop, and is therefore holding a short market position. By using the futures market to take an equal and opposite position of their cash market exposure, hedgers can basically secure a cash market price at a future date. Gains from one market offset losses in the other. In doing so, they no longer have risks associated with price movements, and that’s the goal of putting a hedge on in the first place.
Trading in futures and options involves a substantial degree of a risk of loss and is not suitable for all investors. Past performance is not indicative of future results.
