Let us imagine a city where the only living accommodation is a standard apartment. Every unit is identical, and there is no difference in their values.
Suppose that the current value of the apartments in January, 2007, is $500,000 and that the value fluctuates with market conditions in the normal way.
You can enter a contract to buy or sell an apartment whenever you wish, but the City Fathers have decreed that contracts can only have an completion date on the 3rd Friday in March, June, September, or December each year.
If it is currently January '07, you can enter into a contract for completion in March-07, June-07, Sept-07, Dec-07, March-08 etc.
Any citizen of the city can take either the buy or sell side of the contract. Assume there is a very liquid market for the apartments, so citizens can choose to buy or sell contracts whenever they wish (prior to the contract expiry date).
Now, let us assume that the contracts themselves can be bought and sold in a market place, with the contractual obligations being instantly transferred to the new "owner".
It is not hard to see that if I hold a contract to purchase an apartment at $450,000 in March-07, and the current market value in Jan-07 is $500,000, I should be able to sell this contract to another trader in the market for roughly $50,000, less discount. (You might get less if the market expects prices might drop back a bit before March, or more if the market expects prices to continue rising.)
Alternatively, I might hold a contract entitling me to sell an apartment for $585,000 in June-07. Clearly this contract has value because the current market price has now fallen to $500,000. I should be able to get approximately $85,000 for it, less discount. (Again, you could get less if the market expects prices to bounce back up before June, or more if the market expects a further decline.)
Our final assumption in this hypothetical scenario is that you are required to pay a performance bond, which we call the "margin", whenever you enter an open position by buying or selling a contract. For example, you might be required to put down 10% of the full price ($50,000) to guarantee that you will meet your contractual requirements.
Note that you are allowed to enter a contract to sell an apartment even if you do not currently own one! Thus you could enter a contract to sell an apartment for $530,000 in June-07 (6 months from now) even though you currently own nothing.
If you hold the contract to expiry, you must deliver on your commitment. You can do this by, say, building a new apartment in the interim, or by planning to buy an apartment just before you are required to sell. Obviously, you hope that the market price will decline before you make your purchase, so that you make a net profit.
What I have described is a Futures Market in Apartments. There are three groups of people who might be interested in using this market.
Commercials
The first group is the genuine participants - people who are actually looking to buy or sell an apartment. In a Futures market this group is called the "Commercials".
Say you want to buy an apartment a year from now, and you fear prices will shoot up during the year. You enter a contract to Buy at an agreed price of $500,000 a year from now. This locks in your purchase price, and you will only lose out if prices actually fall during the year.
Conversely, you may be a developer planning to have new apartments for sale eighteen months from now. Your budget is based on selling the apartments at the current market price, but you fear a sudden drop in market prices could take away all your profit. You could enter contracts now to sell apartments for $500,000 in June-08, thus guaranteeing the price you will receive at that time. Of course, you lose out if the market rises during that period, but you are protected against a disastrous market crash.
The original futures markets were in agricultural products. The Commercials were (a) farmers growing crops and (b) organisations purchasing the crops. For example, coffee growers in Brazil and Starbucks are Commercials in the coffee markets.
Farmers sell futures contracts to achieve guaranteed prices for the coming harvest crops, even though they may not have planted them yet. The organisations buy futures contracts to guarantee the prices they will pay for the harvested crops.
Both sides benefit by getting certainty in their businesses, aiding planning and budgeting. They can continue their business operations knowing they are protected from the vagaries of wild price swings.
Hedgers
The next group is known as the "hedgers". For example, you might be a landlord who owns 10 apartments. This is $5,000,000 of capital value, and you are worried that it is going to be eroded during a market downturn which you anticipate will hit over the next 9 months.
You sell 10 contracts at $500,000 and plan to buy them back just before contract expiry in Sep-07. If you are right and the market price drops to $460,000 by then, you will make $40,000 profit per contract, or $400,000 in total. This exactly offsets the decline in the capital value of your 10 units which are now only worth $4,600,000.
However, if you were wrong and market prices actually rise to, say, $530,000, you will be buying the contracts back for a $30,000 loss per contract, $300,000 in total. This exactly offsets the increase in capital value of your properties which are now worth $5,300,000.
In other words, the hedger sets up a futures trade which is neutral whether the market rises or falls. The hedge protects against a potential disastrous loss of value, but at the same time it gives up the opportunity of windfall profits if the market moves in your favor.
A very common hedge occurs in currency markets when a company agrees to make a major purchase some time in the future in a different currency. The risk is that the exchange rate will move against the company before the delivery date, meaning that the price will be significantly higher in the company's own currency than it had budgeted. (Conversely, the rate could move in its favor and the price in local currency would be cheaper.)
The company can set up a hedge in currency futures which guards against an adverse move in the exchange rate, but sacrifices windfall gains if the rate moves favorably.
Speculators
Reverting back to our hypothetical scenario, the final group of people is the one I belong to - the "Speculators". We have no interest in buying or selling an apartment, have nothing to hedge, but just want to make money.
A speculator generally takes a view of the market - expecting it to either rise or fall - and buys or sells futures contracts accordingly. The speculator may hold the contract for years, months, weeks, days or minutes! The speculator never holds a contract to expiry because s/he does not want to have to get involved in actually buying or selling a physical apartment.
Some people see the Commercials and Hedgers as the legitimate players in the Futures markets, with the speculators being looked down upon as mere gamblers who don't create or contribute anything. However, it turns out that the speculator makes an extremely important contribution to the market by providing liquidity.
If the market place were confined to Commercials and Hedgers, then they might well find that when they wanted to buy or sell, there would be no market participant prepared to take the other side of their contract. Speculators, who are prepared to assume risk in return for the chance of profits, fill this gap. Never be ashamed of being a Speculator!
Examples
#1 Let's consider an example of entering a contract to Buy (known as going "Long"). It is now Jan-07 and we go long a June-07 contract at $500,000. A few weeks pass by and the City Fathers publish a report about a predicted property shortage which causes the market price to move up to around $530,000. We decide to take our profit and sell our contract in the Market. Since our contract gives its owner the right to buy an apartment with a current market value of $530,000 for just $500,000 we can sell it and expect to make a profit in the vicinity of $30,000.
#2 Now an example of entering a contract to "Sell" (known as going "Short"). It is Jan-07 and we go short the March-07 contract at $500,000 in anticipation of some bad economic news. Sure enough, the very next week, the City Fathers front up with the bad news that unemployment is gathering pace and the economy is turning sharply downwards. There is a bit of upheaval in the markets, and overnight the value of an apartment drops to $440,000. We now hold a contract guaranteeing a price of $500,000 in March for a commodity valued at $440,000. We go to the market and buy a contract at $440,000 to offset our short contract, taking a profit of about $60,000.
Leverage
One vitally important concept I haven't mentioned yet is "leverage". Remember I said that you have to pay a deposit, or margin, whenever you buy (go long) or sell (go short) a contract. Suppose the margin is $500,000 - the full purchase price. Then in example #1, we pay $500,000 margin and make $30,000 profit (6% return). This is a conventional transaction with no leverage.
If the margin is reduced to $50,000 then the $30,000 profit represents a 60% return on the capital invested! We now have 10-1 leverage on our investment. Suppose that in #2 above, the margin is $40,000. Then the $60,000 profit is a return of 150% When you consider that such returns may have been achieved in just a few days, then the annualized profit potential is enormous.
However, never forget that leverage is a double edged sword! Suppose that in example #2 the market did not plummet as you had hoped. In fact, the price of an apartment rises to $560,000 and when we buy it back we realize a loss of $60,000. Now we have a negative 150% return.
What is worse, we have lost more money than we invested! When there is no leverage, you cannot lose more than you invest even if the price of the underlying commodity falls to zero. In a leveraged investment, you can lose much more than you invest if you don't manage your trade properly.
Summary
o There must be an underlying commodity which is absolutely standardized. e.g. 5,000 bushels of soybeans of a specified grade; 5 times the value of the Dow Jones Industrial stock price index; 100 troy ounces of refined gold. There are literally hundreds of commodities traded in the world's futures markets.
o Participants can enter a contract to purchase the underlying commodity at an agreed price on some future date. This is known as buying a contract, or going Long.
o Participants can enter a contract to supply the underlying commodity at an agreed price on some future date (even if they don't own the commodity now). This is known as selling a contract, or going Short.
o There must be a market where contracts can be freely traded. The contracts are not personalized, so their obligations and benefits are immediately transferable to a new owner.
o As the market price of the underlying commodity fluctuates, the value of contracts changes accordingly. People who buy (go Long) make money when the underlying commodity price rises, and lose money if it falls.
o People who sell (go Short) make money when the underlying commodity price falls, and lose money if the price goes up.
o Participants gain control over the full quantity of the underlying commodity when they buy and sell contracts. Because they only need to deposit the contract margin, this provides a leveraged investment.
David Bennett is an independent Futures Trader. He lives on the Gold Coast of Australia, trading financial and grains futures contracts in Chicago. Visit
http://12oclocktrades.com for more articles.
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