Futures trading can be used for two main purposes; Speculation and Hedging. While most retail futures traders get involved in futures trading for the purpose of leveraged speculation, it cannot be forgotten that the true purpose of futures contracts is for the purpose of hedging.
Hedging using futures is technique most professional money managers use for decades. However, there is one main problem with hedging using futures and that is the fact that the settlement price of futures contracts isnt the actual spot price of their underlying asset. Thats right. In other words, the price of the underlying asset used to determine the worth of each futures contracts isnt the actual price of the underlying asset but a price derived from the actual price known as the Settlement Price. The problem with settlement price is that it can vary significantly from the actual price of the underlying asset and this difference in pricing may cause problems with hedging precisely using futures contracts.
Settlement price is determined at the end of each trading day or trading period by various methods, including price averaging across a certain period, and reflects the future price expectation of the underlying asset at various expiration months. This is why futures contracts of different months have a different price even though they are all based on the same underlying asset. In fact, some futures contracts may end up lower on days where the spot price of the underlying asset actually went up!
As a result of this tracking error between the settlement price and the actual spot price, it is nearly impossible to hedge a position to delta neutrality completely using futures.
This is also why options are becoming the new favorite hedging instrument of professional portfolio managers and are used much more commonly in stock hedging than their single stock futures counterpart.
Options base their price on the actual...