You have almost certainly heard some fictional character wheel and deal over "futures." You've probably heard the phrase "corner the market" or "invest in pork bellies" too. The (quite funny) Eddie Murphy/Dan Akroyd movie "Trading Places" came to its thrilling climax over the price of frozen orange juice, a product that most of us probably forgot existed until we saw that scene.
The question is… what does all of that mean? How does someone get rich buying crates of pre-bacon? Who (other than grocers) cares about sticker price of concentrated Minute Maid?
The answer is futures. The futures market can turn a nickel into a fortune, a fortune into massive debt and (as an added bonus) has quite efficiently exposed pretty much every psychic out there as a fraud.
What Is a "Future?"
To understand the futures market, we first need to understand the concept of a "futures contract." This is an investment product built around buying and selling commodities at a later date.
Literally, a futures contract is an agreement to buy or sell some commodity (usually) on a given date for a given price. A commodity is a raw, physical product such as wood, corn, gold, pork bellies or any other unprocessed material. (It's important to note that, while a classic futures contract deals with commodities, this is not a rule. Many futures contracts deal with intangibles such as currencies or price indices.)
Say Bill and Susan enter the following futures contract: Bill will buy 1,000 pounds of coffee from Susan on Sept. 1 for $1 a pound.
Under this agreement, next Sept. 1 Susan will acquire 1,000 pounds of coffee beans. Bill will then buy them from her for $1 a pound and will take delivery of his beans. There are a few essential elements of this contract
Long vs. Short Position
Every futures contract has two sides: the buyer and the seller. Someone entering a contract to buy the commodity has taken a long position (this is Bill in our example above). The person agreeing to sell the commodity has taken a short position (Susan's role).
The Settlement Date
The settlement date is the date of the transaction. In our example above, this is Sept. 1. It is when the short trader must sell the product and when the long trader must buy it.
Physical Settlement vs. Cash Settlement
You perhaps have noted something odd in our example. Bill has literally agreed to buy coffee beans and will end up receiving barrels and barrels of them, even though he probably doesn't want a single one. What he wants are the profits that come from calling the market right.
As a result, traders developed two settlement types. In a physical settlement delivery of the goods will take place. Susan will acquire the coffee beans if she doesn't have them already and deliver them to Bill on Sept. 1.
In a cash settlement, built for investors, the parties will only trade the cash value of their contract. Bill and Susan won't buy any beans, one will just pay the other based on the current price of coffee relative to the strike price.
The Strike Price
This is the agreed-upon price of the transaction. In our example above, this is $1 per pound. It is the price at which the short trader agrees to sell the commodity to the long trader.
It is also the most essential part of a futures market, because the strike price is fixed regardless of current market prices. This is the whole reason why someone trades futures in the first place.
Why Trade Futures Contracts?
Generally speaking there are two main reasons to trade futures contracts:
Investors trade contracts to speculate on prices in the market. If someone can correctly anticipate how a commodity's price will move, they can make money either buying that asset for less than market value or selling it for more.
Returning to our example above, Bill and Susan have made a contract to trade coffee beans next Sept. 1.
Bill has bet that the price of beans will rise. Say that he's correct. On Sept. 1 coffee sells for $1.10 per pound. Bill can buy the beans from Susan for $1 per pound, then turn around and resell those same beans for a 10-cent profit per pound. Or, in a cash settlement, he will take the difference between the market price ($1,100 for 1,000 pounds of beans) and the contract price ($1,000 for 1,000 pounds of beans) and collect $100 from Susan.
Susan, on the other hand, has bet that the price of beans will fall.
Assume that she's correct. On Sept. 1 coffee costs 90 cents per pound. She will buy 1,000 pounds of beans at the market rate and sell them to Bill at a profit of 10 cents per pound. Or, again, she could take a cash settlement. In that case she would take the difference between the market price ($900 for 1,000 pounds of beans) and the contract price ($1,000 for 1,000 pounds of beans) and collect $100 from Bill.
This is speculation in action. Now, in this case the numbers don't seem worthy of a fortune. However it's important to understand that in real life investors operate on a massive scale, buying and selling millions of units of any given asset. At those numbers, even a 1-cent shift can make someone rich.
Speculation, however, is a side effect of the futures market. Traders first developed futures contracts as a way to stabilize prices, particularly in the often-uncertain world of agriculture.
To see how this works, let's adjust our example above. Assume that Bill and Susan make the same deal (1,000 pounds of coffee on Sept. 1 for $1 per pound), but this time they aren't investors. Susan owns a coffee farm and Bill runs a chain of restaurants.
Each of them wants to secure the best price they can on coffee, but just as importantly they want to secure the most stable price they can. Susan wants to avoid the risk that next September the price of coffee will collapse, leaving her with a warehouse full of near-worthless product. Bill wants to avoid the opposite risk, that next September the price of coffee will skyrocket, pushing up his costs and erasing his profit margin.
In this case they will use a futures contract to "hedge," protecting themselves against future price swings. Susan takes the risk that she'll miss out on potential gains if the price soars, and Bill accepts that he might overpay if the price collapses, but both are confident that they'll receive a price they can accept.
Traders who hedge typically arrange for a physical settlement. Bill actually wants to buy coffee beans, and Susan literally has barrels of them she wants to sell. However in some circumstances a trader will hedge on a cash settlement just to create a counter-cyclical investment. For example, Bill could enter a cash settlement contract that takes a loss if the price of coffee goes down as, essentially, an insurance policy in case the price goes up. He might lose money on his business, but he'll make money on his investment.
The Role of a Futures Market
A futures market is the central hub where traders make futures contracts and a related financial vehicle called an "options contract." (Options are in most ways like futures contracts, with the most significant difference being that one party can choose not to execute the contract if it becomes unprofitable.) It is similar to a stock exchange, the place where traders conduct business and which typically hosts the clearing house.
While futures markets originally were built for agricultural products and still focus on physical commodities, today you can trade a futures contract for virtually anything that has a price. Traders build futures contracts around indices (for example, a contract on what price the Dow Jones will be), currencies, cryptocurrencies and just about anything else. The main limiting factor is finding someone willing to take the other side of the contract.
Margin Trading and the Risk of Futures
No article on futures contracts should end without discussing the extreme financial risk this market can pose. A deal gone wrong can lead to substantial debt.
There are two main reasons for this.
The first is the nature of a futures contract itself. Whichever party loses in a futures contract doesn't lose just an initial investment. They actively owe money to the other party.
This is a crucial difference. Most retail investors assess risk through the lens of the stock market. In that transaction, the investor's losses are capped to the initial investment. For example if you buy a stock for $100 and it goes to zero, you only lose your initial $100.
Not so in the futures market. At the settlement date you will owe the other party the difference between your strike price and the current market price. This is an active loss, and the other party is betting that it will be quite large.
Short positions are more dangerous in this regard than long ones because, while a commodity can't cost less than nothing, there is no theoretical limit to how high the price could climb. In our example, Bill has a maximum exposure of $1,000 (the amount he owes to Susan if the price of coffee drops to $0). Susan, on the other hand, has no such security. She could owe $100 if the price of coffee climbs to $1.10 per pound, or she could owe $10,000 if it climbs to $11 per pound.
In either case, it is possible to lose not just more than you expected but more than you even have.
The second danger of the futures market is called "margin trading." Margin trading is when someone will use borrowed money to cover their contracts. Once a common way to trade stocks, it's now relatively rare on that market but is still quite common in the futures market. The main reason is that it can allow traders to make much, much larger bets (with the consequent gains) than they could otherwise.
Take our example one last time. Bill would like to trade coffee beans and has $10,000 in his account. This is enough to cover any likely losses for a small trade, but he would like to make more money. So he enters a contract to buy 1 million pounds of coffee beans for $1 per pound on Sept. 1.
Bill makes this trade "on the margin," meaning that he agrees to borrow any money that he needs to cover his costs from his broker. His position is now called "leveraged."
Say Bill's trade works. The price of coffee ticks up to $1.10 per pound. He makes $100,000 and repays the broker any money that he had to put down. (This initial deposit is called an "initial margin amount" and varies from contract to contract.)
But what if it doesn't? Say the price of coffee goes down. A banner harvest means that on Sept. 1 beans cost 60 cents a pound. Bill now has lost $400,000 that he doesn't have. His position is far worse than if he had simply made a bad stock pick. He didn't just lose money, he is now actively $390,000 in debt.
Oh, and the Psychics
This one is easy.
Speculating on the futures market involves a bet between two traders. One believes that prices will rise and the other that prices will fall, and each is willing to put money on it. Entire fortunes change hands every single hour on the Chicago Mercantile Exchange (one of the biggest futures markets in the world). This is plenty of incentive for Ms. Cleo to dispense with your love life and focus on next autumn's corn yield.
If psychics were real, they would run hedge funds and have a private island called "Australia."
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