- Hedging / Price Protection
Hedging is strategy that involves cancelling out or reducing the risk is an investment, serving as a form of insurance. Take for example hedge fund manager who has a portfolio that has mirrored the Dow Jones or any other index of stocks, there may be information that is expected to be released that will move the market in a certain direction. The fund manager may not be interested in trading the expected news, but rather he's more interested in protecting his year to date portfolio profit, so he shorts the Dow futures for a contract value that measures up to the current value of his portfolio.
Upon release of the news, if prices fall after negative projections, the stock portfolio will lose money, the futures position, on the other hand, will profit. On the contrary, if prices rise, any gains in the stock portfolio will be offset by a loss on the futures position. This way the fund manager has been successful in protecting his portfolio from any market volatility.
This concept of hedging is also used by farmers, miners, large manufacturers and any, businesses that depend on a sizable quantity of a commodity, were a futures contract can be used to protect the value of their current stocks depending on instabilities in the market. Another good example of hedging is with businesses that do international business, or use raw materials that need to be purchased from foreign currencies, watching the constant devaluing of the dollar, these businesses can secure a currency price today for currency that is to be used at a later date to purchase the raw materials needed.
- Speculation
In the hopes of making short-term profits, speculators assume the risk of price movements that hedges seek to avoid. Speculators strive to profit from fluctuations by purchasing and selling futures contracts.
Trading futures is easy, and does not involve a huge outlay of funds, for this purpose speculators trade based on their anticipation of the market direction, and if in their favor they make gains based on the price. In the same light speculators can loose money if their anticipated market direction was wrong. For this reason brokers hold a good faith amount of cash known as a margin requirement, to protect them against a potential loss. If the price of the future falls, the broker may initiate a margin call, which is a request for additional funds to be provided so as to protect the broker from a downside. If this margin call is not honored by the speculator, the broker liquidates the position at market price.
For example, a speculator has heard rumors that China is looking to buy a sizable amount of soybeans and there hasn't been any grounds to this rumor, however there is a USDA supply and demand report that is to be released, a speculator may do a technical analysis of the market and position himself in expectation of the report. If the report is released and indicates that stocks are low and the demand for soybeans is much larger than the available supply, the price of soybeans will rise, making the speculator a lot of money.
Learn more about futures trading at the futurescafe site: http://www.futurescafe.com is dedicated to taking the complexity out of trading futures for beginners, visit the futurescafe site and check out a wealth of information to get you into the mindset of trading futures.
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Reuters - Even if the government took a large common equity stake in Citigroup Inc, worries would likely persist about the bank's ability to absorb soaring losses in a deepening recession.
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