Futures
Futures are binding contracts that involve risk, andare time bound
Unlike options, they are the obligation (not right) tobuy or sell an underlying asset (commodity, index,bond or currency) at a pre-set price on a specific date
Commodities – precious metals
Gold, silver, copper
Commodities – consumable
Wheat, oil, soybeans, corn, rice
Futures Complexity
Unlike options, futures have complexity based on:
Weather – will the crop be as big as forecasted
Quality – will the crop freeze?
Delivery – even if the crop fares well, can I deliver it timely?
Margin
While you have to be approved to trade options, you need tohave a margin account to trade futures
The initial margin deposit is usually 10% of the contract
Contract for $35,000 requires a deposit of $3,500
Nearly 98% of futures contracts are sold beforeexpiration – physical delivery rarely occurs
Who Uses Futures?
Hedgers and Speculators
Hedger
Producer of the commodity, such as a farmer or oil company
Users of the commodity, such as a jeweler, bakery, energydistributor
Hedgers are protecting their profit margin
Speculator
Professional traders looking to make money off the contract
Try to predict the direction of the market so they can profitfrom the spread between the cost and sale of the contract
Hedge Example: Textile Company
August – company buys 100 December cottonfutures representing 5 million pounds of cotton at$0.58 per pound
Cotton crop fails, reducing supply. Price shoots up
December contract now trades at $0.68
Company can take physical delivery of cotton at$0.58, which is $0.10 less than the market price
Company reduced its risk and saved $500,000($0.10 on 5 million)
Speculators create a market to reduce risk forusers of a commodity
If they weren’t willing to speculate, there would be nomarket
Speculation leads to higher prices
Example: The Real Estate Market
Investors bought properties for investments purposes, not tolive in
They expected to sell them at a higher price
They often put no money down and used interest onlymortgages, thinking they were going to sell and capture theprice appreciation
When values plummeted, investors dumped properties they hadno equity in
This drove prices down because there was excess supply
Zero Sum Game
Futures are not like stocks, bonds or options
Your gain is someone else’s loss
They are more volatile
Because you are always working with a margin position(borrowed money), your risk is greater than with anoption
There is no periodic payment, like a bond would have
There are no dividends, like a stock would have
Hedge Against Price Change
For example, let’s assume cash and futures pricesare identical at $9.00 per bushel
What happens if prices decline by $1.00 per bushel?
Although the value of your long cash marketposition decreases by $1.00 per bushel, the valueof your short futures market position increases by$1.00 per bushel
Because the gain on your futures position is equalto the loss on the cash position, your net sellingprice is still $9.00 per bushel.
Hedge Against Price Change
