The Nature of Future Trading

In the future market, buyers and sellers enter into contract for the delivery of commodities, securities, or cash at specific location and time and at a price which is set when the contract is made. The principal reason for the existence of a future market is hedging-the act of buying or selling a commodity or claim in order to protect against the risk of future price fluctuations. Adverse movements in prices can result in increased costs and lower profits and, in the case of financial instruments, reduced value and yield. Many business firms and investors today find that even modest changes in prices, interest rates, and other costs can lead to magnified changes in their net earnings. Some investors see the futures markets as means to ensure that their profits depend more upon planning and design rather than on the dictates of a treacherous and volatile market.
Hedging may be compared to insurance. Insurance protects an individual or business firm against risks to life and property. Hedging protects against the risk of fluctuations in market price. However, there is an important difference between insurance and hedging. Insurance rests upon the principal of sharing or distributing risk over a large group of policyholders. Through an insurance policy the risk to any one individual or institution is reduced. Moreover, the risks covered by most insurance plans are highly predictable, especially the risk of death.
In contrast, hedging does not reduce risk. it merely transfers that risk from one investor or institution to another. Ultimately, some investor must bear the risk of fluctuations in the prices of commodities or securities. Moreover, tat risk is generally less predictable than would be true of most insurance claims. The hedger who successfully transfers risk through a future contract can protect an acceptable selling price for a commodity or a desired yield on a security weeks or months ahead of the sale or purchase of that item. In the financial futures markets, the length of such contracts normally ranges from three months to two year.