In order to understand the futures market, first you need to know the people making the shots and those who are warming up the bench.
These players could be categorized into three basic groups:
Hedgers or commercial traders are those who want to protect themselves against unexpected price movements.
Agricultural producers or farmers who want to hedge (minimize) their risk in changing commodity prices are part of this group.
Banks or corporations who are looking to protect themselves against sudden price changes in currencies or other assets are also considered commercial traders.
A key characteristic of hedgers is that they are most bullish at market bottoms and most bearish at market tops.
What the hedgehog does this mean?
Here’s a real life example to illustrate:
There is a virus outbreak in the U.S. that turns people into zombies. Zombies run amok doing malicious things like grabbing strangers’ iPhones to download fart apps.
It’s total mayhem as people become disoriented and helpless without their beloved iPhones. This must be stopped now before the nation crumbles into oblivion!
Guns and bullets apparently don’t work on the zombies. The only way to exterminate them is by chopping their heads off.
Apple sees a “market need” and decides to build a private Samurai army to protect vulnerable iPhone users.
It needs to import samurai swords from Japan. Tim Cook, the CEO of Apple, contacts a Japanese samurai swordsmith who demands to be paid in Japanese yen when he finishes the swords after three months.
Apple also knows that, if the USD/JPY falls, it will end up paying more yen for the swords.
In order to protect itself, or rather, hedge against currency risk, the firm buys JPY futures.
If USD/JPY falls after three months, the firm’s gain on the futures contract would offset the increased cost on its transaction with the Japanese sword smith.
On the other hand, if USD/JPY rises after three months, the firm’s loss on the futures contract would be offset by the decrease in cost of its payment for the samurai swords.
In contrast to hedgers, who are not interested in making profits from trading activities, speculators are in it for the money and have no interest in owning the underlying asset!
Many speculators are known as hardcore trend followers since they buy when the market is on an uptrend and sell when the market is on a downtrend.
They keep adding to their position until the price movement reverses.
Large speculators are also big players in the futures market since they hold huge accounts.
As a result, their trading activities can cause the market to move dramatically. They usually follow moving averages and hold their positions until the trend changes.
Small speculators, on the other hand, own smaller retail accounts. These comprise of hedge funds and individual traders.
They are known to be anti-trend and are usually on the wrong side of the market. Because of that, they are typically less successful than hedgers and commercial traders.
However, when they do follow the trend, they tend to be highly concentrated at market tops or bottoms.