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I am having some difficulties understanding the difference between hedging and speculation.

HEDGING AND FUTURE CONTRACTS

I know that if the investor gains when the price decrease and loses when the price increases then a long futures position will hedge the risk.

I know that if the investor gains when the price increases and loses when the price decreases then a short futures position will hedge the risk.

This makes sense to me. So an investor will make gains if he buys the asset if the price decreases and will gain when he sells the assets and the price increases.

SPECULATION AND FUTURE CONTRACTS

But then, in my textbook it states the complete opposite for speculators:

If the investor takes a long position he gains when price increase and loses when price decrease.

If the investor takes a short position he gains when prices decrease and loses when it increases.

My question being, how is it possible for a speculator to make profit when prices increase and he buys the asset

How is it possible for a speculator to gain when he sells the asset when prices are decreasing?

This doesn't seem to make sense to me. I have some learning disabilities so please explain in the simplest way possible. Thanks!

EDIT. what would then be the difference between hedgers and speculators in making profit?

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  • You may have misread the book’s intent. The speculator did the same thing as the hedger, so has the same risk/reward. Where are they different? – Lawrence Nov 15 at 13:03
  • The book states this. For a hedger: If an investor has an exposure to the price of an asset, he can hedge with futures contracts. If the investor will gain when the price decreases and lose when the price increases, a long futures position will hedge the risk. For the speculator: If the investor has no exposure to the price of the underlying asset, entering into a futures contract is speculation. If the investor takes a long position, he gains when the asset’s price increases and loses when it decreases. They do seem different do me – GGGG Nov 15 at 13:10
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A speculator trades futures in hope of making a profit. He makes a profit if he buys and later sells a contract at a higher price (or he shorts a contract and buys it back at a lower price than he sold it for). He is simply trying to profit from price change.

A hedger is someone who buys and sells the actual commodity and uses futures to protect against commodity prices moving against him. This locks in a price and protect against this.

For example, oil prices are rising. An airline can lock in fuel costs by buying oil contracts for future delivery. Or perhaps a farmer senses that grain prices are declining so he 'pre-sells' his crop by selling futures. In both situations, the hedger is buying or selling futures contracts as a substitute for buying or selling the commodity at a later date.

The CFTC defines the following:

  • A commercial trader uses futures in a given commodity for hedging purposes (Hedger)

  • A non-commercial traders does not own the underlying asset and only holds positions in futures contracts (Speculator)

  • Thanks for the output! last question: is what i wrote on my question correct anyhow? i mean the things i wrote on the long position and short position for hedgers and speculators. – GGGG Nov 15 at 13:55
  • Your question (or is that a homework answer?) isn't written concisely with clarity. I had to read it 3 times to figure out who you were referring to and their P&L in each circumstance. – Bob Baerker Nov 15 at 15:12
  • The explanation that i gave under my question are the professors's slides. So pratically my confusion begins where it states that in a long position , the hedger gains profit if the price decreases. But if the speculator is in the long position , then he gains when prices increase. So pratically what the slides says is that they are the opposite . is this correct? – GGGG Nov 15 at 15:32
  • i added a link on the question to show you what the slides are like. – GGGG Nov 15 at 15:34
  • Simplified example: You are speculator and I am the hedger. You sell a 3 month lumber contract for $100k. I own trees which I'll harvest in 3 months, convert to lumber and sell. What will be the price in 3 months? Don't know but I can sell them today for $100k by selling the contract so I do so. 3 months from now, the contract is worth $95k. Both of us made $5k on the contract but my lumber is worth $5 less then than it was 3 months ago (now). I locked in my sale price and my two assets offset each other (futures and raw lumber). – Bob Baerker Nov 15 at 15:57
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I have a gold mine in my back yard (pls keep this a secret). I know that I'll have 100 oz by 12 months from now. As a hedge position, I sell one future contract. I've locked in my sale price, and I no longer worry that the price of gold will drop before my 100oz is mined and ready for sale.

A speculator is on the other side of that contract. In effect, he has 'bet' that in one year the price will be higher and he will take the gold and sell it at a further profit based on that price increase. Me, I actually don't care whether the price changes, either up or down, I'm just happy that my sale price is higher than my cost over the next year.

  • Thanks ! greatly appreciate it. However, is it still fair to say that (in terms of speculation)if the investor takes a short position by selling the asset, then he gains if the price decrease and looses when the price increase?I think it would make sense, since if he speculates that the prices will go down then he better sell the contract imediataley in order to benefit from it. Or, on the other way around, if he takes a long position then he benefits when the price increase since buying the contract now with the idea that prices increase will (inhismind)lead to profit. Is this thinking right? – GGGG Nov 15 at 13:34
  • Yes, long vs short is similar to stocks. It’s effectively a bet whether prices go up or down. The person who is hedging can also be long or short. In my example I sell a contract because I have physical gold in a years time that I wish to sell. There may be a business that requires a purchase of gold, in which case they will go longer a future contract to guarantee a price at some future time.. – JTP - Apologise to Monica Nov 15 at 14:05
  • But if we refer to to a person who is hedging , then it would be the opposite of what i wrote above your answer, correct? meaning that a hedger in a long position would gain when prices go down (from what i wrote in my question, if the investor(hedger) gains when price decrease and looses when price increase a long futures position will hedge the risk). is this right? So short and long postions are opposites in terms of hedgers and speculators? – GGGG Nov 15 at 14:09
  • The hedger, in my examples, does so to neutralize risk. In my answer, I pass the risk to the speculator. If the price falls, he loses money, if it rises, he gains. I suppose if the price increases a lot, I can feel I missed an opportunity, but my own wealth remains unchanged regardless of price movement. – JTP - Apologise to Monica Nov 15 at 14:48
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    The speculator and the hedger gain or lose identically on the futures contract when price rises or price drops. The difference is that the hedger owns the underlying so he has an offsetting position. IOW, if he owns lumber (trees to be harvested later this year) and sells the contract, he locks in a sell price and market price change doesn't affect him. He may have done better had he sold the contract at a higher price price (opportunity loss) but that's hindsight. The hedger's concern is locking an an acceptable price when that price is available. – Bob Baerker Nov 15 at 15:18

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