The future market is composed of different types of agents that go to the futures market for a specific purpose. These agents raise the trading volume and open interest during the contract life. Overall the futures market is composed of speculators and hedgers.
The speculators can be classified into market makers, day traders and position traders.
- Market makers have a useful function of providing liquidity to the market, as they allow new traders to come to the market and trade immediately. They send a large amount of transactions and expect short profits of one or two ticks for each transaction in a very short time frame.
- Day traders are those who participate in intra-day trading, i.e, they enter in a trade and close it before market closes on the same day to avoid overnight risk.
- Position traders may have more than one strategy and can bet on the future price of an underlying asset by going long or short in a futures contract. They can also be involved in spreads positions. Spread is the difference between prices of future contracts of different maturity.
Spread positions can take place between futures contracts with different maturities on the same underlying asset (intracommodity spread), or can take place between futures contracts on two different commodities.
In the first case, speculators bet on the relative prices of the different contracts maturities if they think these differences are unjustified. In the second case, speculators adopt a strategy to take advantage of the relative prices between two commodities. If the difference between two commodities prices is too large, the trader can speculate on a reduction on the gap between those prices in the future and set up a strategy accordingly.
Hedgers are those who enter the futures market to hedge against the possibility of future unexpected movements in prices. Hedgers can take long or short positions to protect for undesired changes in price. A long hedge is when the trader enters in a long futures position to buy the underlying asset at expiration. If a manufacturer needs aluminum as an input for its production process and has uncertainty about the future price of this commodity, he can acquire a futures position to buy aluminum at a specific price on the expiration date of the contract.
Inversely, a short hedge implies selling futures contracts to be protected against the future falls in prices. This can be the case for a gold mine which should make the profitability plan of its business and need to be sure about the price at which they will sell the gold production in the future. At expiration time, the gold mine sells the gold production in the physical market at the current market price and also liquidates the futures contracts at the contract price.
The profits and losses in the two markets offset each other and produce a net wealth change of zero. In practice, there is always a difference between the properties of the futures contract that hedgers find on exchanges and the hedge positions that they need. These differences are related to the different time horizons, different quantities to hedge and different physical characteristics of the asset that is on the contract and the asset owned by the producer.