Future markets explained

Commodity Futures Overview

What are Commodity Futures?

The futures markets are a giant mystery to many people, they know it’s a place where fortunes are made and lost but that’s about the extent of it. Yet these two markets sectors see trading volumes in the Trillions of Dollars every day so there must be something here worth understanding, the people who do understand it seem to be doing a lot of it.

Futures trading may seem complicated but the mechanics of the markets are well within the grasp of 99% of the population. Their origins come from the farmers of the Midwest who needed a way to get fair prices for their raw commodities. Back then, every farmer within five states would converge on Chicago in the fall with all the grains they had grown over the summer, and they’d all be looking to sell. This was a disaster for everyone as the prices would plummet every the fall and skyrocket every the spring. The Chicago Board of Trade provided a central market where everyone could meet to set prices in the summer, for delivery in the fall. Because of the wild seasonal price swings that existed, smart speculators could step in and sell in the spring/summer when supplies were tight and buy in the harvest at a discount. The more speculators caught on to this the less of a profit there was in it for them... because the prices were stabilizing.

The Chicago Board of Trade also provided an additional benefit to the participants. Prior to the exchange, the farmer and a processor (like a bakery or a cereal company) would enter into a private contract with each other to transact a specific amount of product at a pre-arranged price (a forward contract.) The problem is this, Farmer John is not the most honest guy and the bakery down the road just offered him twice the price for his corn.

A futures contract traded on an exchange is different than the forward contract that farmer john signed because of two key features. First of all, the exchanges require you to put up a good faith margin before you can enter the agreement. This means that farmer John and the processor would both have to deposit a margin deposit with a brokerage firm registered to do business on the exchange. To further this safety net, the exchanges require that all accounts be marked to the market at the end of each day. This means that if the price of farmer John’s corn goes up, then the amount of the price move would be deducted from his brokerage account and deposited into the processor’s. At the end of the term, they can do business at the prevailing market price and the difference will be waiting for them in their brokerage accounts.

I know that all happened fast so let me give you another step-by-step example that will make everything clear.

Let’s say that there is a futures market on homes in a hypothetical neighborhood where every house is exactly the same. Each house is worth $100,000 at the close of today’s trading and the margin requirement to trade is 10%. Let’s also assume that you’re a homeowner who’ll need to sell his house six months from now. If you think the prices are going down then you’d use the local home futures market to sell one “house futures contract” at the prevailing market price ($100,000). You’ll be required to put up the 10% deposit ($10,000) and meet any margin calls against you. Now you’ve locked in the price you’ll get for your home even though you will not sell for another 6 months because the futures contract will offset any market moves. I am a speculator who thinks the prices will go up so I take the other side of your trade and buy a house futures contract from you n the open market. We both have a stake in the trade but you’re hedged and I’m just looking for a profit. After a month of little movement the price of homes in your neighborhood had rallied to $105,000. This is not what you were hoping for when you entered the contract but it doesn’t matter because you’ll still get $100,000 for your house. Let me show you why. The margin account you deposited with you broker has been marked to the market at the close of every trading day so your account is now worth only $5,000. Because the market went up and you sold a house futures contract at $100,000 then the difference between today’s price ($105,000) and the price you entered the contract has been deducted from your account ($5,000) leaving you with the $5,000 balance. You could buy back the futures contract, taking a $5,000 loss and sell your house for $105,000. Your net price would bring you back to the $100,000 you were looking for. Since you used a futures contract to lock in a price you got the price. You see how farmer John can’t run away from this one?

My account has grown from $10,000 to $15,000 so I am up 50% and take the profit by selling in the open market to… let’s call him trader John. T.J. has a greedy streak in him and so he is happy to buy my position as he thinks the market will go up even more. After so many months the price of a home in your neighborhood has bone back to $100,000. Your brokerage balance is now back up to $10,000 and I’m glad I took a profit. TJ has had a very different experience however. His account is now worth $5,000 and he may have to put up more money soon if the prices go down any further. Brokerages have to enforce the exchange required minimum maintenance margin for their customer’s accounts. They’ll give you a little wiggle room around the $10,000 initial margin but if you fall below the maintenance margin level you’ll be required to put up more money. For this scenario, let’s call $5,000 the maintenance margin and T.J. is sitting right on it.

Let’s also assume that prices drop $1,000 every day for the next 15 days to an ultimate low price of $85,000. At this point TJ would be out $20,000 from his original buy price so he would be down twice his original deposit. In order to prevent TJ from having a negative account balance and running off to Mexico, his brokerage firm has required him to meet his margin requirement at the end of each trading day. Every day the market went down TJ had a choice to make, he could send in another $1,000 and hold his position or he could get out of the market at the prevailing price and take his loss. TJ chose to hang in there and make the margin calls so his account balance never went below $5,000 because he met all the daily margin calls to hold his position. The good news is that all those calls went from his account to yours. This means that your brokerage is now worth a whopping $25,000. You have made $15,000 in the futures market but lost it in the value of your home. I made a quick $5,000 and TJ lost $20,000.

In the real world there is no futures contract on a neighborhood homes but they do exist for many products, this is just a small example of some of the larger markets.

Metals like gold and silver,
Agricultural products like corn and wheat,
Livestock including bulls, cows, milk and bacon,
Stock market indexes – Dow Jones, Nasdaq and S&P 500
Interest rate products – US 30-year treasury Bonds, Notes and Bills
Currencies – Euro, Yen and Pound
Energies – Oil, Heating Oil, Gas, Natural Gas
Softs – Cotton, Sugar, Coffee

In the example I used the contract size was $100,000, the margin was $10,000 and the maintenance margin was $5,000. One of the largest most heavily traded futures markets is the S&P 500. The Standard and Poor’s 500 index is a long standing stock index that is quoted on almost every news channel every night as a barometer for the health of the over all market. Basically it is a basket of 500 stocks that is averaged together to come to a value. The current value of the S&P 500 is about 1,500. The mini S&P 500 is an electronically traded exchange that sees well over a Million contracts traded a day. The vital stats for one mini S&P 500 futures contract are as follows:

Nominal value
The contract trades at $50 a point meaning the total contract value is (1500 X $50) $75,000. When you buy one contract you will see the same dollar fluctuation as a person who has a $75,000 investment in the S&P 500.

Margin Requirement
The initial margin requirement, which is the amount you need to initiate a trade, is $3,938* (*taken from a major brokerage firm’s website.) The maintenance margin is $3,150*, this is the amount you need in your account at the end of any given day to keep the position on without having to deposit additional funds. If you deposit the initial margin and after three days the market went against you by 20 points (20 x $50= 1,000) then your new account balance would be $2938 so you would be required to bring your account balance back up to the maintenance level to keep holding the position. Therefore, you would need to deposit a bare minimum of $212 ($3150 - $2938 = $212) to bring your account up to the required level but if the market moves against you by even one point on the following day, you’ll be required to make another deposit. It is for this reason that your broker will request funds above the maintenance level if you have plans to hold the position for any period of time thereafter. This is also where much of the risk comes from.

Any time you buy an asset with only 5% down you will see wild price swings. The US Treasury Bonds are one of the largest futures contracts traded. Their ability to hedge against short term interest rate moves has made them a staple for banks and large institutions looking to protect themselves against short term price swings has provided our economy with a large degree of stability. By speculating in these markets you are taking the risk that these institutions need to lay off, its important to understand the fact the the participants are large institutions that have an economic stake in the underlying market and therefore an inherent knowledge of the economic underpinnings therein.

It’s been reported that almost 90% of futures traders lose money. Due to the fact that the markets are a zero-sum game, meaning for every dollar made a dollar is lost by another participant; this means that the 10% of the participants who make money are making what the other 90% lose. This is a giant mechanism for transferring money. There are many risks and rewards but the prudent speculator must do his homework to understand the specific risks involved with his decisions. One of the best collections of books on futures trading can be found at OnTheBid!. Both the Futures>General and Trading sections have Getting Started categories with many good books to help you gain the knowledge you’ll need to understand the futures markets and make sound decisions with your risk capital.

There is a substantial risk of loss in futures and forex trading. You should only trade with risk capital that you can afford to lose without impacting your lifestyle or retirement plans.

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Commodity Futures Overview

What are Commodity Futures?