Hedgers and Speculators
Selling the same wheat future, a farmer with wheat is "buying insurance" while a trader without wheat is "placing a bet". The basis decides how precisely a hedge locks in the price.
Risk warning: forex, CFDs, options, futures and crypto assets usually involve leverage or high volatility, and you can lose more than you put in. This lesson only teaches the concepts; all numbers are for illustration and are not investment advice.
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Text version · Futures Basics, lesson 8: “Hedgers and Speculators”
Selling the same wheat future, a farmer with wheat is "buying insurance" while a trader without wheat is "placing a bet". The basis decides how precisely a hedge locks in the price.
Hedgers: using futures to offset spot risk
A farmer who owns wheat and fears a price drop sells futures first. If prices fall, the short position makes up the lost grain income; if they rise, the extra grain income is lost on the short. A hedger wants certainty.
Speculators: taking on risk by choice
A speculator owns no physical goods, only a futures position, so their P&L swings with the price. It's precisely because someone is willing to take on the risk hedgers don't want that the market has enough counterparties.
What hedging can't lock in: basis
Actual selling price = the price you sold futures at + the basis when you close. Price moves are offset, but changes in the basis aren't. This is called basis risk.
Key takeaways
- Hedgers hold the physical goods and use an opposite futures position to offset price risk: the P&L on the goods is offset by the P&L on the futures.
- Speculators hold no goods. They take on price risk to profit from price moves, and they give hedgers someone to trade with.
- After a short hedge, the effective selling price ≈ the futures price when opened + the basis when closed.
- Hedging removes price risk but not basis risk, and it gives up the benefit of the price moving your way.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Pick “Hedging farmer” and click “Falls to $4.5”: what are the grain sales, short futures and total? Then click “Rises to $7.5”: did the total change?
- Switch to “Unhedged farmer” and check income at $4.5 and at $7.5: how much more or less is it than the hedging farmer's $30,000?
- Switch to “Speculator” and click “Rises to $7.5”: how much did the same short contract lose this time? Why doesn't the hedging farmer have this loss?
- Pick “Hedging farmer” and click “Basis −$0.2”: what does the amount received per bushel become? Then try dragging the basis to +$0.15.
Quiz and explanations
- 1. A farmer has 5,000 bushels of wheat and hedges by selling futures at $6. At expiry spot is $7.5 and the basis is 0. What's his combined income from selling the grain and closing the futures?
- Answer: $30,000.Selling the grain brings $37,500, and the short futures lose ($7.5 − $6) × 5,000 = $7,500, for $30,000 in total = $6 × 5,000.
- 2. Same hedge, but at closing spot is $5 and futures are $5.20 (basis −$0.20). What price per bushel does the farmer effectively get?
- Answer: $5.80.The futures make $6 − $5.20 = $0.80, plus $5 from spot = $5.80, which is $6 + the basis (−$0.20).
- 3. A trader with no wheat who sells 1 wheat futures contract is…
- Answer: A speculator.He has no physical goods to protect; he's deliberately taking on price risk.
Terms in this lesson
- basis (Basis): Spot price − futures price; it converges toward zero by expiration.
- basis risk (Basis Risk): The risk left after hedging because the asset and the hedging instrument don't move perfectly together.
- hedge (Hedge): An opposite trade that offsets the risk of an existing exposure.
- hedger (Hedger): Someone who has (or will have) the physical goods and takes an opposite futures position to lock in a price, aiming to cut risk rather than profit from price moves.
- short (Short): Borrow and sell first, then buy back to return it, betting the price will fall.
- speculator (Speculator): A trader with no physical goods who takes on price risk to profit from moves, providing the other side and liquidity for hedgers.