Futures

Futures are binding contracts that involve risk, and are time bound

Unlike options, they are the obligation (not right) to buy 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 to

have 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 before expiration – physical delivery rarely occurs

Who Uses Futures?

Hedgers and SpeculatorsHedger

Producer of the commodity, such as a farmer or oil company

Users of the commodity, such as a jeweler, bakery, energy distributor

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

profit from the spread between the cost and sale of the contract

Hedge Example: Textile Company

August – company buys 100 December cotton futures representing 5 million pounds of cotton at $0.58 per pound

Cotton crop fails, reducing supply. Price shoots up

December contract now trades at $0.68Company can take physical delivery of cotton at

$0.58, which is $0.10 less than the market priceCompany reduced its risk and saved $500,000

($0.10 on 5 million)

Speculators create a market to reduce risk for users of a commodity

If they weren’t willing to speculate, there would be no market

Speculation leads to higher pricesExample: The Real Estate Market

Investors bought properties for investments purposes, not to live in

They expected to sell them at a higher price They often put no money down and used interest only

mortgages, thinking they were going to sell and capture the price appreciation

When values plummeted, investors dumped properties they had no 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 an option

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 prices are identical at $9.00 per bushel What happens if prices decline by $1.00 per

bushel?

Although the value of your long cash market position decreases by $1.00 per bushel, the value of your short futures market position increases by $1.00 per bushel

Because the gain on your futures position is equal to the loss on the cash position, your net selling price is still $9.00 per bushel.

Hedge Against Price Change