Just about every type of futures account application will ask whether the account holder will be hedging or speculating.
Chances are that if the customer is wondering which box to check off, they are almost certainly a speculator. Even if the trader is planning to be use futures contracts to hedge a position, or somehow planning on adopting a hedge-based trading strategy, they most likely still do not qualify as a hedger.
This can be confusing, as there’s nothing explaining the context of the question. Speculating and hedging are two types of trading roles that deal with futures contracts. Beyond this, the motives and strategies are quite different. So, let’s break it down in plain language.
SPECULATORS –Who are they?
Think of speculators as the risk-takers of the futures market. They don’t want the physical commodity itself. Instead, they just care about betting on the price movements.
What’s their objective in the market?
Speculators aim to profit from price fluctuations. They’ll buy a futures contract if they think the price will rise, and sell if they believe it will fall.
How will they deal with market risk?
Speculators can only generate returns by taking market risks. So, in a way, they seek risk in order to take advantage of market opportunities.
For example: Let’s imagine you’re a speculator who believes the price of gold will rise in the next three months. You buy a futures contract. If the price of gold does increase in that time frame, you can sell the contract for a profit. If it decreases, you’ll face a loss.
HEDGERS – Who are they?
Hedgers are the safety-seekers of the futures market. They’re typically the “commercial” participants who grow, produce, profit, or make use of the actual commodity.
What’s their objective in the market?
Hedgers use futures to “lock-in” prices. This way, they can protect themselves against unfavorable price fluctuations. In other words, their main goal isn’t to make a profit (like speculators) but rather, to manage their risk.
How will they deal with market risk?
Hedgers don’t like price risk. They’re using futures to stabilize the cost of the commodity that is central to their business. That’s why they’re main goal is to lock-in a commodity’s price.
For example: Let’s say you’re a farmer who grows wheat. If you’re worried that the price of wheat might drop by the time you harvest, you can sell a futures contract now at the current price. This way, even if the market price drops in the future, meaning, you’ll be selling your wheat at a lower cost, the “profit” you make from your futures will compensate for your loss in selling the physical product.
A quick and simple comparison
- Speculators are risk-takers looking to make a profit from price fluctuations.
- Hedgers are safety-seekers aiming to lock in prices to protect their businesses from unexpected price changes.
The bottom line
Speculators and hedgers both use futures, but their strategies and objectives differ greatly.
For more information on common futures trading terms, Click Here to View the GFF Brokers Futures Glossary.
Please be aware that the content of this blog is based upon the opinions and research of GFF Brokers and its staff and should not be treated as trade recommendations. There is a substantial risk of loss in trading futures, options and forex. Past performance is not necessarily indicative of future results.