A futures contract is similar to an option in that it is a type of forward contract that is standardized (usually in terms of size of contract, quality of product to be delivered, and delivery date) and traded on an organized exchange. The difference is that futures contracts require the holder to buy the asset on the date specified. If the holder does not want to buy the asset, he or she must sell the contract to some other investor or to someone who wants to actually use the asset. Futures contracts usually focus on agricultural, commercial, and mining products. Organized commodities markets include the New York Coffee and Sugar Exchange; New York Cocoa Exchange; CME Group (pigs, pork bellies, eggs, potatoes, and cattle); Chicago Board of Trade (corn, wheat, soybeans, soybean oil, oats, silver, and plywood); International Monetary Market (foreign currencies and U.S. Treasury bills); New York Commodity Exchange (gold and silver); and New York Mercantile Exchange (platinum).
Economic Need Creates Futures Markets A farmer planting a 10,000 bushel soybean crop in Eureka, Illinois, might want to sell part of it now to ensure the receipt of a certain price when the crop is actually harvested. Similarly, a foodprocessing company might want to purchase soybeans now to protect itself against sharp price increases in the future. Similarly, an orange juice manufacturer might want to lock in a supply of oranges at a definite price now rather than run the risk that a winter freeze might push up prices. These economic needs create futures markets.
Economic Need Creates Futures Markets A farmer planting a 10,000 bushel soybean crop in Eureka, Illinois, might want to sell part of it now to ensure the receipt of a certain price when the crop is actually harvested. Similarly, a foodprocessing company might want to purchase soybeans now to protect itself against sharp price increases in the future. Similarly, an orange juice manufacturer might want to lock in a supply of oranges at a definite price now rather than run the risk that a winter freeze might push up prices. These economic needs create futures markets.
Speculators May Trade in Futures Markets The speculative investor who buys or sells a commodity contract is hoping that the market price of the commodity will rise (or fall) before the contract matures, usually 3 to 18 months after it is written. Futures offer the potential for extremely high profits because all futures contracts by definition are highly leveraged. Depending on the commodity, the volatility of the market, and the brokerage house requirements, an investor can put up as little as 5 to 15 percent of the total value of the contract. Some contracts require a deposit of only $300. Commissions average about $20 for each purchase and sale.
To illustrate the use of leverage in buying futures contracts, assume that Danielle Anthony, a scuba-diving instructor from Largo, Florida, purchases a wheat contract for 5000 bushels at $3.80 per bushel in July. The contract value is $19,000 ($3.80 x 5000), but Danielle puts up only $2500. Each $0.01 increase in the price of wheat represents a total of $50 profit to her ($0.01 x 5000). If the price rises $0.50 to reach $4.30 by late July, Danielle is “in the money” and will make $2500 ($0.50 x5000 bushels) and double her investment by directing the futures exchange to close out her position. The theory is that she could buy the wheat for $3.80 per bushel (as stipulated in the contract) rather than the market price of $4.30 in late July. As an investor, Danielle does not actually want the wheat; she wants her profit by selling her contract. Another investor, perhaps a bread company, is likely to purchase that futures contract to obtain wheat at a below-market price.
The potential for loss exists, too. If the price drops $0.50 to reach $3.30, Danielle would lose $2500. If the price declines, the broker will make a margin call and ask Danielle to provide more money to back up the contract. If Danielle does not have these additional funds, the broker can legally sell her contract and “close out” the position, which results in a true cash loss for Danielle. Because of the risks involved, brokerage houses require their futures customers to have a minimum net worth of $50,000 to $75,000, exclusive of home and life insurance. In each commodity transaction, a winner and a loser will emerge. A buyer of a futures contract benefits if the price of the commodity increases, but the seller suffers. When prices decline, the reverse is true. An estimated 90 percent of investors in the futures market lose money; 5 percent (mostly the professionals) make good profits from the losers; and the remaining 5 percent break even.
Futures Are a Zero-Sum Game Investors need to be aware that they are dealing in very sophisticated markets when they trade in options or futures. Trading in futures is a zero-sum game in which the wealth of all investors remains the same; the trading simply redistributes the wealth among those traders. Each profit must be offset by an equivalent loss; therefore, the average rate of return for all investors in futures is zero. The return actually becomes negative if transaction costs are included. In the world of options and futures, losers outnumber winners.
To illustrate the use of leverage in buying futures contracts, assume that Danielle Anthony, a scuba-diving instructor from Largo, Florida, purchases a wheat contract for 5000 bushels at $3.80 per bushel in July. The contract value is $19,000 ($3.80 x 5000), but Danielle puts up only $2500. Each $0.01 increase in the price of wheat represents a total of $50 profit to her ($0.01 x 5000). If the price rises $0.50 to reach $4.30 by late July, Danielle is “in the money” and will make $2500 ($0.50 x5000 bushels) and double her investment by directing the futures exchange to close out her position. The theory is that she could buy the wheat for $3.80 per bushel (as stipulated in the contract) rather than the market price of $4.30 in late July. As an investor, Danielle does not actually want the wheat; she wants her profit by selling her contract. Another investor, perhaps a bread company, is likely to purchase that futures contract to obtain wheat at a below-market price.
The potential for loss exists, too. If the price drops $0.50 to reach $3.30, Danielle would lose $2500. If the price declines, the broker will make a margin call and ask Danielle to provide more money to back up the contract. If Danielle does not have these additional funds, the broker can legally sell her contract and “close out” the position, which results in a true cash loss for Danielle. Because of the risks involved, brokerage houses require their futures customers to have a minimum net worth of $50,000 to $75,000, exclusive of home and life insurance. In each commodity transaction, a winner and a loser will emerge. A buyer of a futures contract benefits if the price of the commodity increases, but the seller suffers. When prices decline, the reverse is true. An estimated 90 percent of investors in the futures market lose money; 5 percent (mostly the professionals) make good profits from the losers; and the remaining 5 percent break even.
Futures Are a Zero-Sum Game Investors need to be aware that they are dealing in very sophisticated markets when they trade in options or futures. Trading in futures is a zero-sum game in which the wealth of all investors remains the same; the trading simply redistributes the wealth among those traders. Each profit must be offset by an equivalent loss; therefore, the average rate of return for all investors in futures is zero. The return actually becomes negative if transaction costs are included. In the world of options and futures, losers outnumber winners.
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