Futures markets are the meeting places of buyers and sellers of an expanding list of commodities that includes and not limited to, metals, energy, petroleum, financial instruments, foreign currencies, stock indexes, and agricultural products.
The motivations of futures market participants can be divided into two broad categories: hedging, seeking to reduce the risk associated with owning the commodity or financial instrument underlying a futures contract; and speculating, seeking to profit from price changes in those contracts over time. Both approaches contribute to fair and orderly markets.
Hedging / Risk offsetting
For investors who are exposed to the price fluctuation of a commodity or financial instrument, futures provide a way to manage risk. By taking the opposite position in futures, investors can mitigate the impact of movements against the value of their assets.
Example: An oil producer who owns oil (he is long oil) hedges with a short oil futures position (to short something is to sell it). The futures position acts as a temporary substitute for the transaction the producer must enter into a later time in the cash market. . Further, if Oil prices fall, he will suffer a loss on his cash market sale; the loss, however, will be offset by a corresponding gain in the futures market.
Speculation in Futures
Trading futures allows speculators to outlay less money than would be needed to purchase the underlying asset, usually between five and fifteen percent of its total value. As a result, speculators can control more of the underlying and potentially gain greater profits from price swings. In attempting to capitalize on price fluctuations, speculators provide market liquidity, which in turn lowers transaction costs and determines a reliable price for the commodity or financial instrument. This liquidity and price stabilization reduces risk for the marketplace overall.
While offering the possibility of greater profits, this leverage can also work against the speculator by allowing losses greater than the initial margin deposited. If the price of a futures position goes against the speculator, the exchange may require a deposit of additional funds to maintain it. If the price does not rebound, the speculator would lose more than his initial investment.