Why Do People Trade Futures?

In pure economic terms trade is the voluntary exchange of goods and services among individuals and businesses. People are motivated to trade because they expect to gain from the trading activity. They hope to obtain something more valuable than what they give up.

A motive for not trading is the likelihood of loss that will occur when the items being offered are seen as less valuable than the items that would be given in exchange. It is purely a cost benefit decision, when the benefit from a trade is greater than the cost the trade should be made.

There are two basic types of traders, speculators and hedgers. Speculators try to anticipate price movements and trade to make a profit. Hedgers are people that deal in the commodities that underlie futures contracts and need to protect themselves against prices that might move against them. They trade to protect a position they already have. Speculators take on risk while hedgers use futures to reduce risk. Speculators study the events that make prices change and they study historical price movement patterns to try to anticipate price changes and trade accordingly in an attempt to make a profit.

Hedgers, satisfied with today's price use futures to lock in that price for a future period, when they will actually buy or sell the commodity in question. The use of futures as a risk management tool applies to all markets. When a person or a business knows a certain commodity will be needed in the future, they can lock the price in now to protect against prices changes that may happen between now and when the commodity is needed. For example, a cereal manufacturer uses tons of corn every year. There is a surplus on the market now, the buyer for the company locks in today's low corn price by buying futures contracts. If the price increases between now and next season the futures contracts are sold at a profit and the proceeds are used to buy the corn at the higher price. The profit from the futures contracts effectively allows the cereal manufacturer to buy at the original price. If the price of corn goes down the company loses money on the futures contracts but can buy the corn at the lower price and again is able to effectively buy the corn at the original price. The company has successfully locked in the original price eliminating uncertainty and lowering risk from price changes.

The underlying commodity might be an agricultural product a precious metal, a natural resource, a foreign currency, or an interest rate, even stocks, bonds and indexes have futures contracts that are actively traded.

Another feature of futures trading that makes it attractive is the ability to trade on margin. That is a contract can be controlled for a small fraction of its actual value, usually about 1%. This means that traders can control large amounts of futures with small amounts of capital and potentially make huge profits. They can also lose large amounts of money trading on margin. This type of trading increases the risks involved enormously. Traders can risk more than they have and if prices go the wrong way lose everything. It is very important for futures traders to know how to manage and control risks. One way they do this is by setting stop lose orders in case prices move in the wrong direction. Stop loses are a way to automatically shut down trades when losses hit a certain point. These measures can fail when there are rapid price changes, because the stop loss order cannot be filled as quickly as needed. There are no guarantees in futures trading, understanding the risk involved is essential to success.