In order to understand the futures market, you first need to know the major players in the futures market. These participants can be divided into the following three categories:
- Commercial trader (hedger)
- Non-commercial traders (large speculators)
- Retail traders (small speculators)
Those who want to protect themselves from the unpredictable loss of exchange rate fluctuations are called hedgers or commercial traders. Agricultural producers or farmers who want to hedge or minimize the risk of changes in commodity prices are part of this type of trader.
In order to protect themselves from sudden exchange rate or other asset price changes, banks or enterprises can also be regarded as commercial traders.
The key characteristic of hedgers is that they are extremely bullish at the bottom of the market and extremely bearish at the top of the market.
What do hedgers want to do? Let us give an example.
If one day a rare virus spreads in the United States, people infected with this virus will become zombies. Zombies walk around and do things that harm society, such as robbing strangers of their iPhones.
For the majority of fruit fans, without their beloved Iphone, they will feel extremely helpless. This kind of behavior by zombies must be stopped so as not to panic the entire United States.
Guns and ammunition obviously have no effect on these zombies. The only way is to cut off their heads with a sharp weapon.
Apple has seen this market demand and plans to form an army of samurai to protect iPhone users who are attacked by zombies.
In order to form such an army, Apple needs to import a dedicated samurai sword from Japan. Jobs then signed a purchase contract with a Japanese samurai sword manufacturer. These manufacturers need to pay the Japanese yen when Apple delivers the samurai swords three months later.
Apple also knows that if the dollar/yen falls after three months, they will pay more yen for the samurai swords.
In order to protect Apple’s interests, or to hedge against possible exchange rate fluctuations, Apple bought yen futures.
If the dollar/yen falls after three months, Apple’s gains on futures contracts can offset the increased cost of paying the Japanese samurai sword manufacturer.
On the other hand, if the USD/JPY rises after three months, the company’s losses on futures contracts will be offset by a decrease in the cost of paying to buy a katana.
Speculators of large institutions
Unlike hedgers, the purpose of large-scale institutional speculators to participate in foreign exchange transactions is to obtain income. They are not interested in holding the underlying assets, while hedgers are completely uninterested in obtaining benefits from trading activities.
Some institutional speculators are firm trend followers because they buy when the market shows an upward trend and sell when the market shows a downward trend. Before the exchange rate trend reverses, they will continue to increase their positions.
Large institutional speculators are also big players in the futures market because they open huge trading accounts.
As a result, their trading activities can cause huge changes in the market. They usually follow the moving average trend until the moving average trend changes.
Small speculators have smaller accounts. These small speculators consist of hedge funds and retail investors.
They usually move against the trend and often stand in the opposite direction of the market. For this reason, the probability of success of their transactions is much lower than that of hedgers and large institutional speculators.
However, when they can follow the trend, they will maintain greater attention to the top and bottom of the market.