Understanding the Opportunities and Risks

TABLE OF CONTENTS

Introduction

Futures markets have been described as continuous auction markets and as clearing houses for the latest information about supply and demand. They are the meeting places of buyers and sellers of an ever-expanding list of commodities that today includes agricultural products, metals, petroleum, financial instruments, foreign currencies, and stock indexes. Trading in options on futures contracts enables option buyers to participate in futures markets with known risks.

The first recorded evidence of futures trading is from Japan in the 1600s with rice, there is also some evidence that the Chinese were trading rice futures as long ago as 6,000 years! In the United States, futures trading started in the grain markets in the mid 1800s. The Chicago Board of Trade was established in 1848. In the 1870s and 1880s the New York Coffee, Cotton and Produce Exchanges were born. The Chicago Mercantile exchange was in founded in1898. Today there are ten commodity exchanges in the United States and major futures trading exchanges in over twenty countries.

The biggest increase in futures trading activity occurred in the 1970s and 1980s when futures on financial instruments such as currencies, interest rate instruments, and stock market indexes started trading in Chicago. Notwithstanding the rapid growth and diversification of futures markets, their primary purpose remains the same as it has been for nearly a century and a half, to provide an efficient and effective mechanism for the management of price risks. By buying or selling futures contracts — contracts that establish a price level now for items to be delivered later — individuals and businesses seek to achieve what amounts to insurance against adverse price changes. This is called hedging.

The volume of futures and options contracts traded on U.S exchanges has increased from 179 million in 1985 to well over 8 billion in 2011. top

Other futures market participants are speculative investors who accept the risks that hedgers wish to avoid. Most speculators have no intention of making or taking delivery of the commodity, but rather seek to profit from a change in the price. That is, they buy when they anticipate rising prices and sell when they anticipate declining prices. The interaction of hedgers and speculators helps to provide active, liquid, and competitive markets. Speculative participation in futures trading has become increasingly attractive with the availability of alternative methods of participation. Whereas many futures traders continue to prefer to make their own trading decisions, such as what to buy and sell and when to buy and sell, others choose to utilize the services of a professional trading advisor to avoid day-to-day trading responsibilities by establishing a fully managed trading account or participating in a commodity pool which is similar in concept to a mutual fund.

For those individuals who fully understand and can afford the risks involved, the allocation of some portion of their capital to futures trading can provide a means of achieving greater diversification and a potentially higher overall rate of return on their investments. There are also a number of ways in which futures can be used in combination with stocks, bonds, and other investments.

Speculation in futures contracts, however, is clearly not appropriate for everyone. Just as it is possible to realize substantial profits in a short period of time, it is also possible to incur substantial losses in a short period of time. The possibility of large profits or losses in relation to the initial commitment of capital stems principally from the fact that futures trading is a highly leveraged form of speculation. Only a relatively small amount of money is required to control assets having a much greater value. As we will discuss and illustrate, the leverage of futures trading can work for you when prices move in the direction you anticipate or against you when prices move in the opposite direction. top

It is not the purpose of this article to suggest that you should, or should not, participate in futures trading. That is a decision you should make only after consultation with your broker or financial advisor and in light of your own financial situation and objectives. This article is intended to help provide you with the information you should obtain and the questions you should ask in regard to any investment you are considering, such as:

• Information about the investment itself and the risks involved
• How readily your position can be liquidated when such action is necessary or desired
• Who the other market participants are
• Alternate methods of participation
• How prices are determined
• The costs of trading
• How gains and losses are realized
• What forms of regulation and protection exist

• The experience, integrity, and track record of your broker or advisor
• The financial stability of the firm with which you are dealing
• In sum, the information you need to be an informed investor.

Futures Markets: What, why & who

The frantic shouting and signaling of bids and offers on the trading floor of a futures exchange undeniably conveys an impression of chaos. The reality, however, is that chaos is what futures markets replaced. Prior to the establishment of central grain markets in the mid-nineteenth century, the nations farmers carted their newly harvested crops over plank roads to major population and transportation centers each fall in search of buyers. The seasonal glut drove prices to giveaway levels and, indeed, to throwaway levels as grain often rotted in the streets or was dumped in rivers and lakes for lack of storage. Come spring, shortages frequently developed and foods made from corn and wheat became barely affordable luxuries. Throughout the year, it was each buyer and seller for himself with neither a place nor a mechanism for organized, competitive bidding. The first central markets were formed to meet that need. Eventually, contracts were entered into for forward as well as for spot (immediate) delivery. So-called forwards were the forerunners of present day futures contracts.

Spurred by the need to manage price and interest rate risks that exist in virtually every type of modern business, today’s futures markets have also become major financial markets. Participants include mortgage bankers as well as farmers, bond dealers as well as grain merchants, and multinational corporations as well as food processors, savings and loan associations, and individual speculators.

Futures prices determined through competitive bidding are immediately and continuously relayed around the world by wire and satellite. A farmer in Nebraska, a merchant in Amsterdam, an importer in Tokyo, and a speculator in Ohio thereby have simultaneous access to the latest market-derived price quotations. And, should they choose, they can establish a price level for future delivery — or for speculative purposes — simply by having their broker buy or sell the appropriate contracts. Images created by the fast-paced activity of the trading floor notwithstanding, regulated futures markets are a keystone of one of the world’s most orderly, envied, and intensely competitive marketing systems. Should you at some time decide to trade in futures contracts, either for speculation or in connection with a risk management strategy, your orders to buy or sell would be communicated by phone from the brokerage office you use and then to the trading pit or ring for execution by a floor broker. If you are a buyer, the broker will seek a seller at the lowest available price. If you are a seller, the broker will seek a buyer at the highest available price. That’s what the shouting and signaling is about.

In either case, the person who takes the opposite side of your trade may be or may represent someone who is a commercial hedger or perhaps someone who is a public speculator. Or, quite possibly, the other party may be an independent floor trader. In becoming acquainted with futures markets, it is useful to have at least a general understanding of who these various market participants are, what they are doing, and why. top

Market participants

The details of hedging can be somewhat complex but the principle is simple. Hedgers are individuals and firms that make purchases and sales in the futures market solely for the purpose of establishing a known price level, weeks or months in advance, for something they later intend to buy or sell in the cash market (such as at a grain elevator or in the bond market). In this way they attempt to protect themselves against the risk of an unfavorable price change in the interim. Or hedgers may use futures to lock in an acceptable margin between their purchase cost and their selling price. Consider this example:

A jewelry manufacturer will need to buy additional gold from his supplier in six months. Between now and then, however, he fears the price of gold may increase. That could be a problem because he has already published his catalog for a year ahead.

To lock in the price level at which gold is presently being quoted for delivery in six months, he buys a futures contract at a price of, say, $350 an ounce.

If, six months later, the cash market price of gold has risen to $370, he will have to pay his supplier that amount to acquire gold. However, the extra $20 an ounce cost will be offset by a $20 an ounce profit when the futures contract bought at $350 is sold for $370. In effect, the hedge provided insurance against an increase in the price of gold. It locked in a net cost of $350, regardless of what happened to the cash market price of gold. Had the price of gold declined instead of risen, he would have incurred a loss on his futures position but this would have been offset by the lower cost of acquiring gold in the cash market.

The number and variety of hedging possibilities is practically limitless. A cattle feeder can hedge against a decline in livestock prices and a meat packer or supermarket chain can hedge against an increase in livestock prices. Borrowers can hedge against higher interest rates, and lenders against lower interest rates. Investors can hedge against an overall decline in stock prices, and those who anticipate having money to invest can hedge against an increase in the overall level of stock prices — and the list goes on. top

Whatever the hedging strategy, the common denominator is that hedgers willingly give up the opportunity to benefit from favorable price changes in order to achieve protection against unfavorable price changes.

SPECULATORS

Were you to speculate in futures contracts, the person taking the opposite side of your trade on any given occasion could be a hedger or it might well be another speculator — someone whose opinion about the probable direction of prices differs from your own.

The arithmetic of speculation in futures contracts, including the opportunities it offers and the risks it involves, will be discussed in detail later on. For now, suffice it to say that speculators are individuals and firms who seek to profit from anticipated increases or decreases in futures prices. In so doing, they help provide the risk capital needed to facilitate hedging.

Someone who expects a futures price to increase would purchase futures contracts in the hope of later being able to sell them at a higher price. This is known as going long. Conversely, someone who expects a futures price to decline would sell futures contracts in the hope of later being able to buy back identical and offsetting contracts at a lower price. The practice of selling futures contracts in anticipation of lower prices is known as going short. One of the attractive features of futures trading is that it is equally easy to profit from declining prices (by selling), as it is to profit from rising prices (by buying).

FLOOR TRADERS

Persons known as floor traders or locals, who buy and sell for their own accounts on the trading floors of the exchanges, are the least known and understood of all futures market participants, yet their role is an important one. Like specialists and market makers at securities exchanges, they help to provide market liquidity. If there isn’t a hedger or another speculator who is immediately willing to take the other side of your order at or near the going price, the chances are there will be an independent floor trader who will do so, in the hope of minutes or even seconds later being able to make an offsetting trade at a small profit. In the grain markets, for example, there is frequently only one-fourth of a cent a bushel difference between the prices at which a floor trader buys and sells. top

Floor traders, of course, have no guarantee they will realize a profit. They may end up losing money on any given trade. Their presence, however, makes for more liquid and competitive markets. It should be pointed out, however, that unlike market makers or specialists, floor traders are not obligated to maintain a liquid market or to take the opposite side of customer orders.