Futures trading can seem rather complex, but the concept is actually quite simple. One of the easiest ways to explain it is to use an analogy:
Imagine that a farmer offers a horse owner 5,000 bales of haylage to feed their animals through winter at a price of £30 per bale. In doing so, the farmer gurantees that this is the amount the buyer will pay. The buyer is obligated to pay this price. However, the farmer is betting on the fact that prices will not end up being substantially higher than this, and the horse owner on them not being any lower.
This is futures trading; trading futures contracts that allow a particular stock, commodity or asset to be purchased at a pre-determined price.
What is Futures Trading?
Futures are a medium that draw their value from their underlying assets. Their purpose is to allow buyers and sellers to draw up contracts and come to arrangements that protect them from a change in price.
There are four types of futures traders in existence: hedgers, speculators, arbitrageurs and spreaders.
Hedgers trade on the basis of minimising the risk of dramatic fluctuations in price. They tend to be the owner of the underlying asset or other futures contracts of the same ilk. Their transactions go short in order to shield the market against damaging changes in price.
Specualtors are the driving force behind the futures market, providing activity in the form of day trading and swing trading strategies. They transact through brokers like Sucden Financial, buying and selling futures contracts in an attempt to make a profit through their speculation. They indulge in the most high risk form of futures trading.
Arbitrageurs are a very specialised type of trader. Their sole purpose is to spot price anomalies and utilise them to their advantage. This is a highly technical area, and traders usually rely on advanced systems and super computers to detect these anomalies between futures contracts and their underlying assets automatically, before anyone else can seize on the opportunities that they provide.
Spreaders use ‘futuresspreads’ to inform their trades, utilising the variation in price and rate of change of different offsetting futures contracts. This is quite hard to understand; essentially, these traders create futures positions that can only fluctuate within a set limit, increasing the likelihood of profit and lowering commission rates for spreaders. Thus, their aim and intention is to reduce their risk and improve the probability that they will make a profit.
Voila – the four types of futures trading explained!