Hedging

• Hedging is one of two basic strategies used in futures markets, the other being speculating. Hedging is a way for investors to transfer their risk to speculators. Consider a commodities trader who owns 30,000 bushels of corn worth $4 per bushel. If the trader fears the price of corn will drop below $3 per bushel by the end of the year, she may want to enter into a futures contract with a speculator to sell that corn for $3.50 per bushel at some point in the future. If the price of corn does drop below $3 per bushel, the hedger will be protected. If, on the other hand, the price of corn rises about $4 per bushel, the hedger will have missed out on an opportunity to make a greater profit.
  
  

Speculating

• Speculating involves entering into futures contracts with hedgers in an attempt to recognize profits on movements in the market that are different that those anticipated by hedgers. For example, a bond holder might own a $10,000 bond and expect interest rates to rise, which would cause the value of the bond to fall on the secondary market. That investor might wish to enter into a futures contract to sell the bond at a discounted price at some date in the future. A speculator might expect that interest rates will not fall, but will actually rise. This speculator would take advantage of the investor's wish to avoid risk by entering into a futures contract, hoping to make an profit.
  
  

Options

• Options are another type of derivative investment instrument used in conjunction with futures contracts. An investor might have a hunch that the price of her stock will fall in the future, but may be unsure. To hedge against that risk, she could enter into a futures contract, but may be worried that she will miss out on a potentially large profit opportunity. This investor could instead purchase an option to sell her stock via a futures contract. An options gives an investor the right, but not the obligation, to purchase a futures contract. If purchased, a futures contract ensures that the investor can choose whether or not to sell her stock at a predetermined price at some point in the future.
  
  

Spreads

• A spread is a strategy used in options trading on futures markets that takes advantage of discrepancies in prices sought by different hedgers and speculators. For example, a trader in oil futures might be seeking a futures contract to sell a certain level of the commodity for $10,000 on September 30. Another trader might be looking to enter a futures contract to purchase that same level of the commodity for $20,000 on October 30. A third investor might take advantage of this opportunity to create a spread transaction by entering into both contracts, holding the commodity and selling it a month later for a $10,000 profit.