Futures markets are commodity markets where investors essentially agree to buy a set amount of some commodity at a set price at some date in the future. Futures markets originated in the early 18th century in Japan, and by the beginning of the 19th century they had spread to Europe and the Americas. Early futures markets originated out of necessity, with sellers needing to hedge against large swings in the price of their product, by getting a guarantee from buyers that no matter what the market looked like in a few months, they could get the price they needed for it.
Oil futures are one of the largest of the futures markets, along with corn and gold. They account for billions of US Dollars (USD) in trade every day, and help to drive the price of oil at the consumer end. Oil futures can be a bit confusing to some people, as it seems strange that an investor would want to be buying large quantities of something like oil, but it is precisely because they don’t want to actually own the physical oil that the oil futures market works.
There are basically two groups of people involved in oil futures: hedgers and speculators. Hedgers are people who actually want to be buying and selling oil, the physical commodity. These hedgers want to be moving around the product, but want to minimize the risk they might encounter based on market fluctuations. Speculators, on the other hand, don’t want to own the oil at all, but they do want to take a bit of risk and possibly make quite a bit of money. So they buy in to future oil contracts, from the hedgers, based on what they think the price of oil will be.
Oil futures can either be hedged short or hedged long. A speculator who buys a short hedge of oil futures is buying a contract in the future saying they will sell a certain amount of oil at a certain price. A speculator will profit off of a short hedge should oil prices fall. A speculator who buys a long hedge of oil futures is buying a contract to purchase a certain amount of oil at a certain price. That speculator will profit should oil prices rise.
The way that hedgers ensure they are safe no matter what happens in the market is by leveraging both the spot market and the market for oil futures. The spot market is the cash market, based on the daily price of oil, and by taking an opposite position in the spot market from what they take in the futures market, they ensure that no matter which direction the market goes, they wind up neutral.
Speculators buy only oil futures -- they never buy in the spot market -- so they aren’t hedging their purchases to remain neutral. Instead, they are betting that the market will move either up or down, and that they will profit off of that shift. If they are correct, they can make large amounts of money in relatively short periods of time, but if they incorrectly gauge the movement of the market, they can lose just as drastically.
