Why Futures Are So Popular

Futures contracts are hugely popular instruments amongst a diverse cross-section of traders, from private individuals through to massive, multi-million dollar hedge funds. Futures provide traders with a flexibility that isn’t available with many other instruments, and allows longer-term positions to be taken through a highly leveraged, cost-effective channel. Two of the main purposes of futures contracts in professional trading circles are hedging and speculating, both of which serve their own unique purpose and reflect futures in all their practical glory.

Hedging

Hedging is the process of taking two complimentary positions to offset losses and guard against the risk of wayward trading positions. A hedge (a term which gives ‘hedge’ funds their name) is designed to both minimise risk while also preserve trading capital, and is set up in such a way as to allow natural inverse correlations between two markets to offset the losses in either. As a piece of the hedging puzzle, futures contracts can be a fantastic tool in giving traders the positions they need to take in order to present the hedging opportunity.

Consider the following example. OPEC, the body responsible for setting global oil supply, meet and decide to dramatically cut oil production over the coming months. In this scenario, a trader might look to buy shares in airlines on the FTSE while also buying oil futures, in the hope that oil prices will rise as a result of the OPEC decision.

The hedge in this case might lead to a situation where if oil prices rise, the gains in value on the futures contracts less any slight hampering in price value that could arise from higher costs for the airlines would realise a profit, whereby a fall in oil prices would boost the margins (and thereby the share price) of the airlines, while the oil futures could be offloaded as soon as markets head south.

This scenario could present a credible hedge for traders, which naturally reduces the earnings potential but simultaneously minimises the risk of either trade, making it an attractive option for fund managers conscious of maintaining their trading capital.

Speculation

In contrast to hedging, another common strategy for traders engaging in the futures market is speculation. Speculation is the process of forecasting longer-term price movements and backing a futures contract with a view to selling the asset later down the line when prices move as predicted. The key benefit with speculating through futures contracts is that you can amplify gains in the event that markets move in the right direction by hanging on to your futures until their expiry date, whereas you can cut your losses by selling futures contracts early if it looks as though your position is falling short.

It is apparent that futures contracts can be employed to give traders an advantage – whether that’s in hedging, speculating or in conjunction with any other trading technique or strategy. As a result of their unique construction and the intensely liquid market for futures contracts, they are the perfect evergreen tool for traders looking to diversify their investment strategy.

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