Future contracts are extremely attractive for speculators as they provide tremendous leverage. By paying a small margin amount, speculators can take higher exposure of the underlying, thereby increasing their reward potential as well as the risk. A person who is bullish on the price of the underlying can BUY a future contract while a person who is bearish would SELL the future contract.
Hedging is an act of protecting or guarding the investment against an undesired price movement. Suppose a long term investor owns a portfolio of stocks worth Rs 10 lacs. Although he is optimistic about the stocks he has in the portfolio, he is not very comfortable with the overall movement of the market. The price movement of a stock is dependent both on the micro (profitability of the company, its growth potential, business model, management competency etc) and the macro factors (GDP growth of the country, interest rates, overall state of economy etc). Such an investor can hedge his portfolio by selling Index Futures (like Nifty future) and thereby removing the risk of macro variables from his portfolio.
Another way to hedge using future contracts is by buying the futures of an index/stock when the cash to buy the underlying would be available on a future date. Say a person is sure to receive cash inflows of Rs 5 lacs in 2 months’ time, which he wants to, invest in stocks. However, he is very bullish on the markets and wants to invest as early as possible. What can he do? He can simply pay the margin amount and take the relevant LONG exposure in future contracts. This will hedge him from the risk of losing out on the profits if market were to go up in the next 2 months. It must be noted here that hedging does not necessarily mean reduced possibility of losses. Like the long term investor we discussed above might lose on both cash and futures positions if market moved up while his stocks fell.
An arbitrageur gains by buying the stock and going short in its future contract when the price of the future contract is higher than its theoretical price. When the price of the future contract is less than what it should be, the arbitrageur gains by going long in the future contract and selling the underlying in cash market.