Thought # 17                                                                      March 2009
Author: Bill Thurston

What are Futures and Futures Contracts?

Futures have been around for a long time.

Farmers never knew how much grain to plant because they couldn't predict the demand at the time of harvest.  The buyers of the farmers grains never knew if the farmer would have enough grain to meet their needs at the time of harvest. In an effort to help both the farmer and buyer, they would reach an agreement that would be implemented at the time of harvest. The farmer would agree to deliver to the buyer a certain amount of grain of a certain quality and delivered in a certain way. The buyer would agree to purchase that product at a certain price.

That is a futures contract.

Each futures contract must state the price per unit, type, value, quality and quantity of the commodity and the month the contract expires.

Here is an example of a futures contract.

A farmer enters into a futures contract to sell 5,000 bushels of corn of a certain quality to a buyer for $4.00 a bushel in August 2009.

How is a future contract made?

Both members of the contract need to be members of a commodity exchange in order to make a contract. Futures contracts are traded in the U.S. as well as abroad. Futures contracts on the major domestic agricultural crops are traded several places including the Chicago Board of Trade (CBOT) http://www.cbot.com/ . Oil futures could be purchased at http://www.nymex.com/index.aspx .

Both members need to have an account with the exchange where money can be added or removed on a daily basis.

When a futures contract is made, the buyer and seller need to put money into their account based on the size and type of contract. This initial cash is called the margin requirement. You must always maintain this margin requirement in your account.

How does the futures contract work?

Each day the commodities price (corn in our example) changes based on market conditions. This is similar to stock prices changing daily.

Let's say the price of corn, in our example, increases to $4.10 a bushel on a particular day. This would not be to the benefit to the farmer because he has the price locked in at $4.00. The farmer for that day would have lost 10 cents a bushel on 5,000 bushels or $500. The buyer would be buying at 10 cents below market value so the buyer would be saving $500. So, at the end of the day, the farmers account would decrease by $500 and the buyers account would increase by $500.

The seller is said to have the short position and the buyer is said to have the long position.

If your position is bettered, money is added to your account. You now have more money in your account then is required by the margin requirement and you could request the additional money be sent to your bank account. This is called a payout.

If your position is worsened, you will be asked to add more money to your account to bring the balance back to the initial margin requirement. This is called a margin call. When a margin call is made, the funds usually have to be delivered immediately. If they are not, the brokerage can have the right to liquidate your position completely in order to make up for any losses it may have incurred on your behalf. This is very bad.

That's it!

At the settlement date, the contract is closed and one party receives a profit equal to the loss of the other party.

To exit the commitment prior to the settlement date, the farmer or buyer has to offset their positions by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations.

But after the settlement of the futures contract, the buyer still needs corn, so he will buy his corn in the cash market. The cash market is a market in which commodities, such as grain, gold, crude oil, or computer chips, are bought and sold for cash and delivered immediately. This is also called the spot market.

Let's say the contract ended with corn at a price greater than $4.00. The farmer would have lost money in the contract but would be selling the corn at a higher price. The farmer's loss in the futures contract is offset by the higher selling price in the cash market. This is referred to as hedging.
 
Extending future contracts to the general case

 

A futures contract is really more like a financial position. The two parties in the corn futures contract discussed above could be two speculators rather than a farmer and a buyer. In such a case, the short speculator (farmer)  would simply have lost money while the long speculator (buyer) would have gained what the farmer lost. Neither would have to go to the cash market to buy or sell the commodity after the contract expires.

Who are the players in the futures markets?


Hedgers

Farmers, manufacturers, importers and exporters can all be hedgers. A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks.

Hedgers trade short to secure a price now to protect against future declining prices.

Hedgers trade long to secure a price now to protect against future rising prices


Speculators

Speculators do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. They aim to profit from the very price change that hedgers are protecting themselves against. Hedgers want to minimize their risk no matter what they're investing in, while speculators want to increase their risk and therefore maximize their profits.

Speculators trade short to secure a price now in anticipation of declining prices.

Speculators trade long to secure a price now in anticipation of rising prices.

Leverage is very good or very bad
Futures contracts are highly leveraged because the initial margins that are set by the exchanges are relatively small compared to the cash value of the contracts in question. For example, you can leverage a $100,000 US Treasury Bond with a ~$4000 margin. The smaller the margin in relation to the cash value of the futures contract, the higher the leverage.
Highly leveraged investments can produce two results: great profits or greater losses.

Pricing and Limits
Prices change daily but have a lower limit of change (called a tick) and a upper limit amount of change. This offers some protection for investors from massive daily changes.

 

Spreads
Spreads involve taking advantage of the price difference between two different contracts of the same commodity. There are t
hree basic futures spread types:

 

Intra-market Spread

This is the most common futures spread where both the long and short are on the same commodity.  An example is July Corn vs. Dec Corn.

Inter-commodity Spread

Buying a commodity product and selling a related commodity product as in the Long. An example is soy meal vs. short bean oil spread.

Inter-market Spread

Buying a commodity product on one exchange and selling a commodity product on another exchange. An example is long Kansas wheat vs. short Chicago wheat)

 

How do you make money with spreads?

1. Long leg of the futures spread moves up; the short leg moves down. (Ideal!)

2. Long leg of the futures spread goes up; the short leg doesn’t change much.

3. Long leg of the futures spread doesn’t change much; short leg moves down.

4. Long leg of the futures spread moves up faster than the short leg.

5. Short leg of the futures spread moves down faster than the long leg.


How could a person get involved?
You can have your own account. You can open an account with your broker. You can join a commodity pool.

 

Final Thought

The size of the financial mess we are in isn't because of simple investment tools like stocks or bonds or mortgage backed securities. It's because of high leverage financial tools like futures contracts. That is why I addressed this somewhat complex issue. The tool has real value to buyers and sellers of commodities but there are those that simple want to invest a little and make a lot while adding little value to this United States. These people or businesses become very rich in good time and when they lose in bad times, some cry for government help. Rewarding bad behavior by bailing these people seems to undermine the basics of free enterprise.

 

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