The futures and options market is one of the most mysterious vehicles in investing.
Vaguely understood as the province of i-bankers and wealthy robber barons, "futures" doesn't mean much to most people. It made Dan Akroyd and Eddie Murphy rich in "Trading Places." Men wearing monocles will trade pork bellies in exclusive clubs, but what, exactly, they're trading remains a prominent question mark for the layperson.
Which is unfortunate, because not only are the futures exchanges a pretty important part of the marketplace, but they also can actually add value to your portfolio when used carefully. So, to help the average investor understand how this exchange works, here are seven of the most commonly asked questions about futures trading explained.
What is the futures exchange?
Let's start with the basics.
When you hear someone talk about trading shares of orange juice, that person is not talking about Tropicana; he's referring to futures. The futures exchange is a specific marketplace, like the stock exchange. Except instead of trading pieces of a company, a futures trader will buy and sell contracts for future delivery of specific commodities, in the hopes that he can later sell that contract on for a higher price.
The exchange is where this trading happens. It's a highly sophisticated, highly specific marketplace, but a marketplace nonetheless.
How does it work? (In other words, what are futures?)
Futures are essentially bets against long term value. They're contracts for the delivery of some specific goods, bought in the anticipation that those goods will increase in value.
Take pre-ordering the next Harry Potter book from Amazon. I go online and agree to buy the book for $30, and in exchange Amazon agrees to deliver it upon release. I have taken what's called a "long" position, the agreement to buy, and Amazon have taken the "short" position, an agreement to sell. Critically, we have now both insulated ourselves against future shortages and future surplus.
If something happens and J.K. Rowling allows only a handful of copies to be printed the value of this book will skyrocket, but I'm still guaranteed a copy at $30. On the other hand, if in a fit of generosity she releases the manuscript online for free its value will plummet… but I'm still on the hook for a copy at $30 (refund policies notwithstanding).
This is basically how a futures market works. Someone who buys coffee futures is literally purchasing a contract to receive a certain amount of beans, down to a slated date for delivery. His hope is that something (maybe a flood, maybe disease, maybe labor strikes) will drive up the price of coffee beans, allowing him to later sell this contract for a profit. This is the deal. If he forgets to sell those futures sooner or later, someone will back a truck full of Arabica up to his front lawn.
Does it have to be dry goods?
One of the areas where investing starts to walk like a casino and quack like a casino is that there's a market for just about anything that might gain value someday. The futures market trades an incredibly wide array of products.
Take, for example, the next YouTube sensation. A futures product could easily be packaged around some 14-year-old's career. Investors would buy in, owning the future results of that recording contract, and then either collect their profits or sell the contract to someone else if the kid goes full Bieber.
That's an extreme example, but not too out there. A more common abstract trade is currency. Futures traders can buy up bulk amounts of currency in the hopes that it will gain and lose value, thus potentially making them a bundle.
How do you make money?
Most futures traders rely on penny-theory trading. They buy large contracts and wait for prices to change by as little as half a cent. That might not seem like a lot, but when you're the proud owner of an entire freighter's worth of rice, a tiny change in market position can suddenly multiply to a lot of money.
Of course, that works both ways. If you own 5,000 tons of rice, movement of a single penny per pound loses you thousands of dollars, and traders can't hold on to these contracts indefinitely in hopes that the prices will rebound. (Remember, it's a contract for specific delivery.) As a result, it's easy to lose your shirt on small movements in the marketplace.
It's also a highly sophisticated market. As referenced up top, a lot of our cliched "rich-guy" speak is borrowed from the futures market specifically because it sounds so arcane. Concepts like cornering the market (buying up all available units of a given product, thus creating a shortage and driving up the price) have entered the vernacular because they're complicated but also quite real. This is particularly true of short-selling, which is very common on the futures exchange.
What is shorting?
Shorting is when a trader borrows shares of something and sells them, with the promise that he'll buy those same shares back to return at a later date. The goal is for a commodity to lose value, making it cheaper to buy back than it was to originally sell.
Imagine, for example, that I borrow your Dodge pickup for the weekend and flip it at a used car lot. Then, before I have to give it back on Monday, I go out to another dealer and buy that same model truck back and turn over the keys. If the Kelly blue book value dropped over the weekend, I actually end up ahead (having sold it for more than I bought it back for). If trucks went up in value I get hosed, because I still have to buy the truck back no matter how much the thing costs.
How does this relate to me?
First, the futures exchange is a major and important part of the marketplace. One estimate by the Futures Industry Association suggests that in 2014 alone more than 21.87 billion contracts were traded. An enormous amount of money moves through this system, and anyone with an interest in finance (which should be everyone, at some level) should at least have an understanding of how this market works.
It's also valuable to understand how extremely dangerous this market can be for the lay person. As the U.S. Commodity Futures Trading Commission warns on its website, "Trading commodity futures and options is a volatile, complex and risky venture that is rarely suitable for individual investors or 'retail consumers.' Many individuals lose all of their money, and can be required to pay more than they invested initially."
Commodities fraud is a big problem, and the volatile nature of the futures market makes it ripe for get-rich-quick scams. Knowing more about this market helps the average investor protect themselves from con artists and predatory traders.
Finally, to almost directly contradict everything above, this market can be valuable for the average investor. With its known counter-cyclical behavior, commodities can help insulate a portfolio against economic downturns. The key is working with a trusted professional who can guide you into safer, more diversified waters.
How do I learn more?
There is also a wealth of information available on the CFTC's website, which is aimed at both professionals and laypeople. TD Bank also has some helpful information on their site in video format, for those who want a little more pizzazz.
But most importantly, anyone thinking about actually getting involved in this market should consult a professional. The futures market is vast, interesting and complicated. Investing in it takes a lot of money, and if you're not careful you can easily lose your shirt. Make sure you go accompanied by someone who knows those waters well.