In Trading Futures, there are actually 4 types of futures traders active in the Futures Market. Each of these brings liquidity to the Market place needed for smaller investors to make a profit. You will see these 4 types of traders active at the largest US futures exchanges, the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX). If you are a futures trader, chances are, you will be one of the following...Hedgers, Speculators, Arbitrageurs and Spreaders. In this article we'll start with the first, hedgers.
What is a Hedger? Hedgers primarily deal with the commodities side of Futures Trading. You can be either a buyer or seller of Futures contracts and still be a Hedger. The whole idea behind hedging is to mitigate risk. There are those who buy Futures, for example, manufacturers who buy commodities or airlines who buy gas.
Lets look at a prime example of hedging Futures.
Take a bread manufacturer. When a bread manufacturer knows that he will be making a purchase in the future for wheat, he takes a long position (buys) futures contracts to hedge his position. Say the bread manufacturer wants to sell 1,000 loaves of bread weekly. He knows how much wheat he needs over the next year. He knows the current market price of wheat and wants to mitigate his risk, or hedge, so he works out a futures contract with a wheat grower to buy so many bushels of wheat at the current market price to be delivered over the next year. That way, should the price of wheat go up at any time, he has covered his bases by locking in his price ahead of time. What would happen if there were a tornado, or a flood and wheat became scarce, the price would skyrocket. So this way he controls the price of wheat and knows exactly what price to sell his loaves of bread for in order to make a profit.
Lets look at the other side for a moment. We know why someone would buy futures contracts to mitigate risk. Why would someone take the other side and sell the contracts?
If a farmer knows that he will be selling his wheat at harvest time, he would take a short position (sell) futures contracts to mitigate his risk. He knows what the current market price is. If he arranges a contract at the current price for a future delivery (namely after harvest), he is guaranteed the current price. Say that come harvest time, the price drops because there is an abundance of wheat. By arranging the price ahead of time, he has already locked in his sale. He knows how many bushels he will reap, what his profit is, etc.
There are a multitude of contracts that can be hedged. Certainly the commodities, wheat, rice, corn, soy, etc. There is also silver and gold. A dental lab, for instance, buys a futures contract in silver and gold, knowing they use the product for fillings. Airlines buy gasoline / diesel futures contracts years in advance for future delivery when the price of crude is low. Name any commodity and you will find hedgers ready to buy and sell well in advance of their delivery date.
Understand, there is risk attached for both buyers and sellers in any futures deal. Buyers risk that although they negotiate at the current price, by the time delivery occurs, the price could be much lower and they could have bought the commodities for cheaper. Sellers risk that although they negotiate at the current price, by the time delivery comes, the price could be much higher and they could have sold the commodities for greater profit. Futures trading is all about woulda coulda shoulda, the fish that got away. You may never get the highest price nor the lowest price. So long as you make a profit, that's all that really matters.