Hedgers have a position in the underlying commodity. They use futures to reduce or limit the risk associated with an adverse price change. Producers, such as farmers, often sell futures on the crops they raise to hedge against a drop in commodity prices. This makes it easier for producers to do long-term planning. Similarly, consumers such as food processing plants often buy futures to secure their input costs. This allows them to base their business planning on a fixed cost for core ingredients, such as corn and wheat. Other examples include: airlines hedging fuel costs or jewelry manufacturers hedging the cost of gold and silver. This makes it easier for these companies to manage price risk and stabilize the cost passed on to the end-user.
Many speculators are individuals trading their own funds. Traditionally, individual traders have been characterized as individuals wishing to express their opinion about, or gain financial advantage from, the direction of a particular market. Electronic trading has helped to level the playing field for the individual trader by improving access to price and trade information. The speed and ease of trade execution, combined with the application of modern risk management, give the individual trader access to markets and strategies that were once reserved for institutions.
A portfolio or investment manager is responsible for investing or hedging the assets of a mutual fund, exchange-traded fund or closed-end fund. The portfolio manager implements the fund’s investment strategy and manages the day-to-day trading. Futures markets are often used to increase or decrease the overall market exposure of a portfolio without disrupting the delicate balance of investments that may have taken a significant effort to build.
Proprietary Trading Firms
Proprietary trading firms, also known as prop shops, profit as a direct result of their traders’ activity in the marketplace. These firms supply their traders with the education and capital required to execute a large number of trades per day. By using the capital resources of the prop shop, traders gain access to more leverage than they would if they were trading on their own account. They also gain access to the type of research and strategies developed by larger institutions.
A hedge fund is a managed portfolio of investments that uses advanced investment strategies to maximize returns, either in an absolute sense or relative to a specified market benchmark. The name hedge fund is mostly historical, as the first hedge funds tried to hedge against the risk of a bear market by shorting the market. Today, hedge funds use hundreds of different strategies in an effort to maximize returns. The diverse and highly liquid futures marketplace offers hedge funds the ability to execute large transactions and either increase or decrease the market exposure of their portfolio.
Market makers are trading firms that have contractually agreed to provide liquidity to the markets, continually providing both bids (an expression to buy) and offers (an expression to sell), usually in exchange for a reduction in trading fees. Increasingly important are electronic market makers who as a group, provide much of the market liquidity that allows large transactions to take place without effecting a substantial change in price. Market makers often profit from capturing the spread, the small difference between the bid and offer prices over a large number of transactions, or by trading related futures markets that they view as being priced to provide opportunity.