Futures Education, Hedging vs. Speculating
Recently, futures trading has grown immensely, and the great thing is, it can only get bigger. You may be asking yourself “What’s lead to the massive growth in commodity trading? Well, the answer is obvious, high yields. Unlike equities, futures trading give you leverage, dramatically increasing your profit potential. As we’ll discuss, there are two main strategies which account for these yields, speculation and hedging.
Since futures trading has become quite the trend, we felt our readers would appreciate some more education on the topic. In this article, we will cover the critical concepts of hedging and speculating in the futures market. This will allow you to understand basic futures trading, citing applications, benefits and more. As you’ll see, futures trading can be a extremely lucrative if the strategy and risk are managed correctly. First things first, let’s cover the meaning of speculation and its place in the futures market.
By definition, “speculation” is purchasing a “naked” position, hoping the market will move in a certain direction. For example, a trader would be speculating if they bought “long” crude oil futures at $72, hoping to cash out at some point above that price. As you can see, a speculator would earn money if they chose the right direction of the market, using either a buy (“long“) or sell (“short“) position to profit. Typically, speculators are stuck to their computers analyzing charts, waiting for the latest price break or news release. Once it happens, the traders jump on the opportunity, positioning themselves to profit. Even though speculation can lead to high yields, the point to remember is, it can also lead to high risk.
In contrast to speculation, “hedging” is defining risk by protecting yourself on both sides of the market. Though this may sound confusing, it’s far safer than speculation. For example, a futures trader may buy 10 “long” crude oil positions at $72, and if the price was moving below $72, they’d buy 10 put options to “cover”. By doing this, they offset positions and are no longer responsible for any losses below the option strike price. Typically, a smart hedger covers their “naked” positions if risk presents itself. Even though hedging can hurt yields, it keeps futures accounts more stable. Typically, hedgers are focused on risk prevention first, using low-risk option strategies to profit.
Though most traders either speculate or hedge, there are times when both strategies should be used. For example, a savvy hedger could use “long” futures positions to take advantage of an upswing in the Gold market. In contrast,a smart speculator could hedge during volatility, buying options or futures to reduce their exposure. The reality of futures trading is, hedging and speculation are best used together. In fact, each strategy has distinct flaws which prohibit it from succeeding alone.
As you can see, futures trading is very complicated, but it can also be VERY lucrative. If you’re a smart futures trader, you’ll always have a hedging strategy in place. Though some traders strictly speculate, the fact is, it’s not the best long-term plan. The smart money always hedges, benefiting from speculation only during market swings. Remember, despite the attraction of high yields, risk should always be the main focus. Without proper risk management, your yields will always disappear in the long-run.
In summary, hedging and speculating are the main strategies of futures traders. Speculation aims for high yields by predicting price movement, while hedging focuses on reducing risk to stabilize returns. Though either strategy can generate profit, it’s always best to use both when trading futures. Whether you choose to speculate or hedge, the reality is, futures trading is only as risky as the strategy. Remember, despite your desire for high yields, it’s always best to start off conservative. All it takes is one big loss in future trading, and you’ll realize the true power of leverage…
InsideTrade LLC Staff