Explain how future contracts can be used for hedging and speculation?

Answer 1

Hedging: You have some stock you THINK might fall in price. Oh...you have some ConocoPhillips. You bought it at 20, it's now 40 and you're happy as a clam. But wait! You know Conoco's biggest chain of dealerships, the Flying J truck stop chain, is being purchased by Pilot, who owns a huge hunk of Marathon Oil. Translation: there is a distinct possibility Conoco's stock will go down because Pilot could start selling Marathon diesel at Flying J stores. To protect yourself against completely losing your ass over this deal, buy a one-year put in the $30-$35 price range depending on how risk-averse you are, and let things ride until the Pilot-Flying J merger is completed. (If you're seriously risk-averse you'd just get out of the position, but you'd hate yourself in the morning if the stock price went up after you did.)

Speculation: Let's deal in a nice cyclical stock--Brunswick. It's cyclical because of what they make--boats and Bowling center equipment. The stock goes down in the winter because people don't buy boats or replace bowling center equipment in the winter, and up in the summer because that's when people do both. If you'd like to speculate in Brunswick, make a prediction as to how low you think it's going to sink, sell puts for a little above that, and IF you were right you'll make out like a bandit.

Answer 2

Two kinds of people buy forward contracts: commodity users and speculators.

Since most of the forward contracts are between farmers and crop buyers, you'd hedge a forward to protect against getting too much of the stuff. Let's use soybeans this time. You are Cargill and you just entered into a forward contract to buy Mr. Smith's crop when it comes in. You've been dealing with him for 40 years, and his land generally produces 50,000 bushels of soybeans. To protect yourself against him bringing you 55,000 bushels, you buy a put option, giving you the right but not the obligation to sell, on 5000 bushels of beans. If you get the usual 50,000 bushels from him, you allow the contract to expire worthless; if he has a great year, you exercise the contract and your problem goes down the road in a parade of trucks.

Now! If you're a speculator who's stupid enough to buy a forward, hoping you can sell it to a commodity user around harvest time and make lots of money, you hedge this thing by purchasing enough put options to get rid of the crop if you have to settle on it.

My basic rule when dealing in commodities: ONLY buy derivatives with commodities underlying if you would buy the commodities themselves. If you sell bread, buy wheat futures. If you make cars, buy steel futures. If you do neither, stick to precious metals and securities.