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Thursday, August 7, 2008

What is hedging and speculating

Just about every product that you consume would likely cost dramatically more without the commodities futures markets.

Because of the intrinsic risks associated to being in business, lacking the ability to shift risk, a manufacturer/producer of goods or services would be forced to charge higher prices, and the consumer would have to pay those higher prices.

This shifting of risk to someone willing to accept it is called hedging.

Manufacturers could effectively lock in a sales price by going short an equivalent amount of goods with futures contracts.

If a mining company knew that they were going to sell 1000 ounces of gold in several months, they could protect themselves for a future price decline by going short 10 gold futures contracts today.

If the price of gold fell by $30 in the following months, they would receive that much less in the cash marketplace for their gold, but earn that much back when they offset their short gold futures position.

The futures price will eventually become the cash price. A user or buyer of goods can use the futures market in the same manner. They would need to protect themselves from a future price increase, and therefore go long futures contracts.

The person willingly accepting a risk does so because of the opportunity to profit from price movements, this is known as speculating.

The cotton in your shirt, the orange juice, cereal and coffee you had for breakfast, the
lumber, copper and mortgage for your home, the gas or ethanol that you put in your car all would be priced many times higher without the participation of speculators in the futures markets.

Through supply and demand market forces, equilibrium prices are reached in an orderly and equitable manner within the exchanges, and world economies, and you, benefit tremendously from futures trading.

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