As in all futures trading, there are two basic types of participants in financial futures markets — hedgers and speculators. Hedgers want to reduce and manage price risk, while speculators hope to make a profit by assuming market risk.
Hedgers in financial futures include institutions such as banks and insurance companies, large multinational corporations, pension plans, and mutual funds. Despite their name, “hedge funds” actually often act as speculators in the marketplace. They utilize an array of complicated and varied strategies that seek to not only hedge against other cash investments held by their investors, but also to enhance returns through speculative positions.
As an example of a hedger in the financial futures markets, put yourself in the position of a mutual fund manager running an S&P 500 Index fund that contains individual stocks that comprise the S&P 500 Index. You are worried that a shaky U.S. economy and incidents of global terrorism could negatively impact the index and your returns, yet you can’t disrupt your stock holdings. However, you could take a short position in S&P 500 Index futures, and if the stock prices fall, you could then buy back the index futures at a lower price. That would allow you to offset losses to the stock holdings in your fund. Of course, if your worries were unfounded and the stock prices rose, you’d lose money on the futures transaction. But, the idea is to use futures as a hedge to minimize your potential risk.
While speculators can include large institutions and funds, many are individual traders who provide valuable liquidity to the marketplace. An individual trader who commits his or her own capital to act as speculator on a particular exchange provide market liquidity by constantly buying and selling throughout the trading session and are viewed as important participants in the market by shouldering risk. While the term local has been used to designate those trading in the open-outcry markets, the Commodity Futures Trading Commission defines this new breed of electronic traders “E-locals,” but they are often more simply known as independent traders.
A speculative trader typically takes a position in the futures markets—without any underlying cash stock market position—with the hope of making a profit. In the example above, the speculator may take the other side of the portfolio manager’s trade, thinking it’s unlikely a terrorist incident will soon strike and that stock prices will hold up.