Hedger or Speculator?

What does it mean to be a speculator? Are speculators hedge fund traders staring at a computer screen and inputting orders as fast as they can? And are farmers who trade corn futures considered speculators?

Speculators are concerned with price changes in the market. They make their buying and selling decisions based on where they believe a commodity will be trading at some point in the future, whether that’s one day away or a year away.

Speculators also know for certain that the futures market is going to fluctuate. They look to profit from those market fluctuations because they are pure risk-takers.

Hedgers want to reduce or eliminate price risk when markets move. Hedgers are generally risk-averse and look to the futures market to help eliminate some of their risk.

A hedger will always have an exposure to a particular commodity. For example, a corn farmer is inherently always long corn while a bread maker is always short the input of wheat.

Think of futures as a type of insurance that gives producers and consumers the ability to lock in prices and take away the risk of a fluctuating market.

Too often, even the market’s best hedgers can be led astray, using a strategy called a “Texas hedge.” That is an investment that increases exposure to a particular risk. It would be like a corn farmer buying corn futures. If the corn futures market goes up, the farmer can sell his physical product for more money, as well as sell his futures position for a gain. The farmer wins on both the physical and the financial.

But if the markets go down, not only could his futures lose money, but his cash sales might be less than his production costs, so he loses there, too.

A Texas hedger is someone who just reclassified himself out of the hedger category and firmly into the speculator category.

The relationship between the two groups operates as opposites. The chart shows the net position in the corn market of both groups. When the commercials (farmers) sell a lot, the non-commercials (speculators) are buyers.

The best traders, whether hedgers or speculators, prepare their game plans before making any trading decisions.

Producers need a detailed breakdown of their costs so they can establish profitable selling levels in their marketing plans.

Speculators must have plans to preserve capital. A good speculative trader follows his game plan and will get out if he’s wrong — and get out when he’s right.

In the classic trading movie, “Wall Street,” Gordon Gekko says, “Greed is good.” Unfortunately, greed too often leads to poor decisions and poor results in the bank account. Recently, several high-profile commodity-based hedge funds shut down due to big losses and a shift in investor preferences.

No matter what category you’re in, CHS Hedging is committed to helping you make the right decisions for the right reasons.

Since 1986, CHS Hedging has been a futures commission merchant providing brokerage and risk-management services, as well as educational programs. CHS Hedging offers a variety of choices, such as futures, options and OTC Compass contracts, to help customers manage risk and take advantage of market opportunities

FUTURES MARKET: An auction market in which participants buy and sell commodity futures contracts for delivery on a specified future date.

FUTURE: A financial contract obligating a buyer to purchase an asset at a predetermined future date and price.

OPTION: A financial derivative contract that offers the buyer the right, but not the obligation, to buy (call) or sell (put) futures at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).

MARGIN: Collateral the holder of a future has to deposit to cover some or all of the credit risk.

LONG THE MARKET: To buy a security. Most of the time someone long the market wants it to go higher. The exception is someone who is long with put options; he wants the market to go down.

HEDGING: The practice of using futures or other financial instruments to reduce risk of an exposure to a physical asset.

HEDGE FUND: A limited partnership of investors that uses high-risk methods in hopes of realizing large gains.

This information is provided by a research analyst of CHS Hedging, LLC, and should not be construed as a recommendation to buy or sell any commodity contract.

“When you look at a commodities market, you need hedgers and speculators. If you don’t have one, you don’t have a market. That’s how it works.” — T. Boone Pickens