Basics of the Futures Market.
What are Futures?
Futures contracts resemble gambling very much as it involves predicting the prices and market swings of different products and in particular commodities. The way in which these work is by two parties coming together and agreeing on the price of a commodity or a financial instrument for delivery at a future date.
Futures are traded on exchanges around the world such as the London Metal Exchange,Chicago board of trade,Chicago Mercantile Exchange and the Intercontinental exchange to name a few.
History of the futures trade?
Historically farmers used to come to markets in the hope of selling their products but many of their produces were left to rot when the supply exceeded demand and so as time went on market places became centralised and it provided farmers with the option of selling their produce on the spot or for forward delivery. Many of the products were not even produced when the the contracts were agreed upon.
How the markets work?
In many ways futures trading is very similar to having a contract with your mobile phone provider and this is why, the price of the contract is fixed and locked in and even if the price of the instrument changes for better or for worse the contract price cannot be moved.
This may seem very cool but it all depends on which side of the table you are sitting on. For instance a restaurant owner buys a soybean contract for 500 bushels at $ 700/bushel from a farmer at a total of $350,000.
They might agree that delivery should take place in 3 months so if it was June when the contract was agreed upon then the delivery would be in September. Between these 3 months a variety of factors could occur such as a excess in soybeans and so the price might fall to $500 in which case the farmer would make a profit of $100,000 or on the other hand if there is a shortage of soybeans the price might rise to $900 and in which case the restaurant owner would make a profit of $450,000.
Market participants?
The participants in the futures market is categorised into two:
- Hedgers
- Speculators
Hedgers
Hedgers try and protect themselves against price volatility and so minimises the risk of the price either going up or down. The people who take a long position (buyers of the commodity) would want to secure the lowest price going and the people who takes the short position (sellers of the commodity) would want the highest price going.
For example:
A coffee farmer and a café enters into a futures contract the coffee farmer would want the highest price possible /lb for coffee, whereas the café owner would want the lowest price /lb for coffee. If when they enter the contract let’s say September for delivery in December they might agree on a price of $100/lb for 30,000 pounds of coffee so that would be $3,000,000. If the price of the coffee rises to $105/lb then the coffee farmers would have been better off not entering the contract but if the price decreases to $95 then the farmer would have successfully hedged.
Speculators
Another market participant are speculators who aim to make the highest possible profit and naturally would increase the risks associated with them as well. Speculators buy contracts at a cheap price in the hope of prices rising. Speculators commonly purchase contacts from hedgers who are trying to protect themselves from risk. Speculators are not concerned with owning the commodity rather seeking to buy contracts that are cheap at the moment with the anticipation of prices rising.
For example: A speculator might be looking for some coffee futures or oil futures that are at the moment at a low cost due to a oversupply of the commodities. In about two or three months there might be a shortage of these and prices might skyrocket and so this is the time that they sell and make their profits.
In many ways the futures market resemble the real estate market as the hedgers take the part of home owners or prospective owners who wants to buy the house for living in and speculators resemble real estate developers who purchase distressed property and sell them on when the prices rise when the market is booming.
In conclusion futures markets are an important market not just for the economy but for the whole world as this is one of the main markets in which food prices are set.