Types of Derivatives Trading
Derivatives transactions are often classified according to the objectives of the transacting parties. One objective is hedging, which involves the transfer of an unwanted risk to another party. An agricultural chemical company, for example, might want to lock in a price of soybeans for future purchase rather than face the risk of changes in the price. A long hedge means that the hedger will be compensated not only for unfavorable price movements but for favorable movements as well; the hedger has traded away price risk by locking in, for better or worse, a fixed price.
A second objective is speculation, which involves taking on risk from another party in order to profit from price changes. In the long soybean hedge example, the party on the other side of the trade might be a speculator hoping to profit if the price of soybeans falls. By acting as a source of liquidity to potential hedgers, speculators are a necessary part of a market.