Futures
Futures provide an exceptional opportunity for profit, which must be balanced against the risk involved. A futures contract is simply a binding contract to buy or sell something at a future date. The price is agreed and the quantity and quality, if appropriate, is set. A futures contract is a derivative, as any value it has as a contract is derived from something – it’s only later that the actual goods will change hands for money, as the agreed transaction.
One of the reasons that futures were invented was to help farmers control their costs and predict their income without suffering wild fluctuations. A farmer could know in advance how much they would be paid for their crop or livestock when they sold it six months hence, and this would allow them to plan their expenditure, and even to switch crops if another would give them better returns.
The other party to this futures contract might be a cereal manufacturer, who would like to control and regulate his costs, and secure a supply of grain for future production. Both the farmer and the manufacturer would gain out of having a predictable future, so they wouldn’t really be concerned if the market price in six months time was a little higher or lower than they had agreed. What they are doing is ‘hedging’ their positions so that they don’t have any surprises.
Now the farmer and the manufacturer would not purposely make themselves out of pocket. The price that they agree at the outset is one that they are both happy with, so the futures contract has no bias or built in disadvantage. It is only over the course of time that it may become obvious that the price will be higher or lower than the market price that will be available when the contract comes due.
Enter the speculator. Wherever there is the prospect of money to be made, then someone will try to do so. Suppose it looks like there will be a bumper crop, so supply and demand will push the price lower. Do you think the speculator would like to hold a contract where a manufacturer has promised to pay a certain price, regardless of what the market price is? Of course. That means that the futures contract takes on a value, and can be bought and sold to different people.
Generally futures contracts have a value that is derived both from the basic price of the goods and from how long it is until the date it must be settled, called the “time value”. Some futures contracts are easier to value than others. For instance, you can have a futures contract on gold, or something else that does not deteriorate. The seller in the contract could simply borrow money to buy the gold now, and pay interest on the loan until the settlement date. This is called a “cash-and-carry” way of figuring a value. If the contract was worth more than the current price plus interest, then the seller would make money without any risk, and everybody would do that until the opportunity was closed, so that sets a limit on how high a price could be in the contract.
You can get futures contracts on many different things. The ‘thing’ is usually called the ‘underlying’ or ‘underlier’, because it is the underlying basis of the contract. As above, the underlying can be a solid physical item such as gold. The underlying may be perishable, such as crops or “pig bellies”, and this is the basis of commodity trading. But the underlying could also be single stocks or stock market indices, and the futures contract would be based on what value these things attained by the expiration date of the contract.
Futures contracts are a commitment to a transaction, a buying and selling, of the underlying at the future expiration date. You can buy and sell futures contracts before they expire, as they change in value over time, and this is how you would make a trading profit. Some contracts have actual deliverables, but it’s not likely you would let the contract reached that point – you may like bacon, but 40,000 pounds of frozen pigs’ bellies, the standard size for that contract, is probably more than you will eat in a lifetime. But a futures contract on a stock market index would only be settled with the cash difference, and not by you receiving a bunch of different stocks. Depending what you decide to trade, you will learn what the rules are for settlement, as well as the standard dates of expiration.
I have to tell you that futures are not the only way to commit to buying and selling something in the future. Before futures were standardized by the markets, there was a very similar thing called a forward contract. Forward contracts were specifically written to suit the two parties who wanted a contract. They could specify the price, the date, the quantity and type of stuff to be bought and sold; in fact they could put whatever they wanted in the contract. And forward contracts are still used today when two parties can agree on specific requirements.
Forward contracts don’t work so well for trading. As they are so specific, there is not much of a market for buying and selling them. In contrast, futures contracts are highly standardized, specifying in detail the amount and quality of the goods involved, and a set date in the month when the buying and selling should take place. This means the market for them is generally highly liquid, and they are easily traded, which is much better for our purposes. As they are traded on an exchange, the performance is also guaranteed, whereas with forward contracts you have to rely on the other party going through with their side of the deal.
Now the great advantage of futures contracts is what is called ‘leverage’, which basically multiplies the power of your money. You see you don’t have to pay the transaction costs for the buying and selling you’ve agreed to in the contract until that future date when the sale takes place. All you have to have is a small percentage, called a ‘margin’, on deposit with your broker. Yet if you go right through to the sale date, you will make a profit from the change in total value of the goods.
As an example, say you put down 10% of the contract price as a margin – the percentage varies depending what the goods are, and what your broker will want. And say the goods went up 10% above the contracted price by the time the contract was due. That 10% represents a doubling of your margin money, and this is an example of leverage.
Of course, it’s not all great. If you get it wrong, and for instance the price fell by 10%, you would lose money – in this case, all of your original stake. You could even lose more than your original stake, if the price fell more sharply. Leverage works both ways. But if you are a winning trader, then you can get much greater gains more quickly trading futures.
That brings us to one little housekeeping detail, and that is to do with something called “marked to market”. Each day your broker will look at the contracts you hold, and update their value according to the market price of the futures contracts. So the value of your account varies every day. If your account drops in value too much, your broker will ask you for more money, so that he has some assurance that any losses would be covered. It’s just his guarantee against you finding you can’t pay up with a losing position.
When your broker asks for money, this is called a ‘margin call’, and you have a limited time to respond. If you don’t send more money, the broker can do what he needs to do to protect himself from loss, which may include selling your contracts and any other holdings you have with him, such as stocks themselves. So you must make sure that you are always able and willing to respond to a margin call.
The upside of marking to market is that if your contracts increase in value, then your account is growing even though you haven’t closed out any deals yet. You could even trade some more with the extra money you get, but I would advise caution in getting over committed.
That’s the bare bones of how the futures markets work, and they’ll be discussed in more detail when we come to the training module about using technical analysis with futures.
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