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The primary function of futures or derivative contracts and index futures trading is not solely for speculation, as is popularly perceived to be, but rather it serves to enable financial professionals and institutions to hedge their current
positions in equities, commodities etc, in order to limit losses or act as an
insurance policy against any unforeseen "events". This is best illustrated by an
example:
Hedging Using Derivatives As A Form Of Insurance Policy
 Lets say fund manager George just bought 10 million shares of Intel (INTC) as
his firm's technical and fundamental analysis indicates a bottoming in the stock
price. What George didn't figure in happening is receiving "whisper numbers" on
another company in Intel's sector, lets say Advanced Micro Devices (AMD), that
their earning's guidance for next quarter looks bad. George knows that when the
word gets out into the open market, what will normally happen is a knee jerk
reaction to the news and all stocks in that sector will be hammered hard.
Realizing this, George wants to protect the value of the Intel shares he just
bought so he goes to the S&P500 index futures market and tries to discretely
"short sell" a number of contracts amounting to a value close to his Intel
shares in the hopes of creating a 1:1 hedge. (The S&P500 index futures
contract is a derivative of the S&P500 Cash Stock Index. It has an
electronically traded E-mini version which is one fifth the size of the main
pit-traded contract. Other popular futures contracts used for hedging &
speculating include the Nasdaq & Dow Jones Index Futures.)
How Does the Hedge Work?
What George has done is that he has created a hedge in order to limit the
loss on his Intel position. He is expecting the S&P 500
index futures to also drop on the bad earnings news and his gain on his
"short" futures position should mitigate his loss on his "long" Intel position.
The premise is that the overall market will react badly to this news since Intel
is a blue chip S&P 500 component and it is in a very important semiconductor
sector which should affect the performance of the entire economy.
Low Liquidity & Spooking The Markets
 Why did George short sell the S&P 500 index futures and not just sell
his 10 million Intel shares? The problem is liquidity. If George goes into the
open market and tries to sell-off his huge position, he will definitely spook
the market. When the bad news hits the wires, the liquidity on Intel at a
price close to where George bought will be practically zero as the market will
adjust the price to a level where the buyers are comfortable in buying! For
George to let go of his huge Intel position would have meant negotiating a big
block trade with a large institution at a significantly marked down price. In the case of index futures trading, the liquidity is normally better which may enable him to have
sufficient time to put on a hedge.
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