How does futures trading work?

Question

What are you actually buying? If I go and buy winter wheat futures or whatever, and do not sell my contract in time, do I actually receive the pork bellies or Brent crude oil? How does one make money?

Answer 1

You are doing one of two things.

You are either buying the right to BUY something at a price before a date certain, or buying the right to SELL something at a price before a date certain.

If you purchase the right to buy oranges at $1.00 per bushel and it goes up to $1.50, you make $.50 for every bushel you have a contract on. Usually you just sell the contract, you don't actually take delivery. If it goes to $.75 per bushel, the contract merely expires and you lost the cost of the contract.

If you purchase the right to SELL oranges at $1.00 per bushel, and the price goes to $1.50, it expires and nothing happens but you lost the cost of the contract. If it goes to $.75, you'll get bought out for the difference.

With either, you know what your maximum exposure is.

When you sell contracts, you can get really burned. If you take $.10 for a contract to buy oranges at $1.00 and it goes to $2.00, you're okay, you got your dime and it expires.

If they go to $.10 per bushel, you better really like orange juice.

Answer 2

I can't really improve on the answer given by the first responder as far as mechanics go except to say that a futures contract OBLIGATES you to a quantity and price. This is a HUGE difference from the options markets, futures do NOT expire worthless, and you do NOT know what your potential exposure will be.
It is not a zero sum game. The futures markets (commodity markets) are used as a hedge by either the consumers of the commodyity, or the producers of the commodity as well as the plain old speculator that is risking his/her own capital to try to make a profit. They use the contracts to lay off the risk of production or cost of comsumption. The airlines are some of the biggest players in the fuel and oil markets.

Say you are a wheat farmer. The cost to grow and harvest your crop are pretty transparent. If you could lock in a porfitable price on say 25% of your crop - one that would pay all the bills associated with all the costs involved that is a pretty good deal. Sure, you may give up potential profit if the price of wheat rises, but the security of locking in that price is very valuable and this makes the futures markets not a true zero sum game.

You make $ the same way you would in any other market, buy low and sell high. These markets are highly speculative, and full of people that are MUCH more savy and familiar with them than you are. They are also different than a traditional stock market in that you can lose more that you actually invested. In my opinion, they are best left to the pros, but there are many non-pro investors that do quite well in them - I suppose its all about how much can you afford to lose.

In short, futures markets were designed to transfer risk between parties with different risk and times horizons (prodcer/consumer lays off risk on speculators)

Yes, they will ask you where you want your pork bellies or Brent Sea crude delivered and they can stick you with phyiscal delivery, although this is very rare.

Answer 3

Open4one is describing the workings of options - either calls (the right to buy the underlying issue at a set price by a set date) or puts (the right to sell at a set price by a set date). You are not buying the right to buy or sell. That is futures options. With futures you are buying the actual commodity at some future date/price. There are options on stocks and on futures. The underlying issue on a futures option is a futures contract which is a contract (not an option) to buy or sell the actual commodity. If you own an option an option on Dec wheat and the price is out of the money on the expiration date then it does expire worthless. If you have an actual futures contract position and the price goes against you you will have to have sufficient funds to cover that. It is essentially the same as stocks but with bushels of wheat instead of shares of a company. In theory you have have the actual wheat delivered but in practice the contracts are settled for profit or loss.

Warning: Futures markets are dominated by players with vested interest such as ADM for wheat. They also move at warp speed and may go for several days at limit moves. Ain't no playground.

Answer 4

It is a zero sum game. Some body wins and somebody loses for a zero sum.
If you buy and it goes up and you sell you win, if you buy and it goes down and you sell you lose.
If you sell and it goes down and you buy it back you win, if you sell and it goes up and you buy it back you lose.

Futures is very risky because of the huge amount of leverage involved.
Most contracts traded never take delivery on the commodity they represent. They are usually closed out before the first notice day or rolled into the next month. Most speculators that trade futures DO NOT MAKE Money, They lose money.

If want to make a small fortune in the futures market, start with a large fortune.

Answer 5

The poster that said the open4one is correct in that thay are talking about options. But the posters that said that a futures contract obligates you to purchase/sell the asset at a future price and date is not fully true. You would if you held the contract till expiration. A FORWARD contract is an OBLIGATION. When you get into a Forward contract, you are indeed obligated to buy/sell the underlying asset.

The way futures contracts came about where when farmers wanted to lock in prices for their crops when prices were favorable, but their fields wouldn't be ready for harvesting for several months. For example, farmer Joe has large corn crop and prices are at a level he likes (say $3.00 a bushel), but his field won't be ready for harvesting for 3 months. So, farmer Joe would sell corn contracts for delivery in 3 months at $3.00 a bushel. On the other end, Kelloggs uses corn for it's Corn Flakes cereal and Kelloggs likes the $3.00 per bushel price, but Kelloggs will not need delivery for 3 months, so Kelloggs buys the corn contracts for delivery in 3 months at $3.00.

So, let's say corn prices go down to $2.25 per bushel. Farmer Joe has made money because even though the price of corn went down, he made a profit on his corn contracts (he sold, ie shorted, so he makes money when prices go down). Kelloggs will have lost money because instead of buying for $2.25 a bushel, they'll be buying for $3.00 or to put it another way, they bought the contract (long) so with prices going down they lost money. The opposite is true, if corn went up, farmer Joe would lose money and Kelloggs would have made money. The positions that both Farmer Joe and Kelloggs took were to lock in prices at current levels and the futures contracts is a way to potentially offset adverse prices in the future.

The way you make money is by the price of the futures contract fluctuating. Individual traders such as you and I add liquidity and price stablization to the markets. So, let's say you are looking at corn and corn is trading at $3.00 and you think corn is going up. You would buy say a Dec '06 corn contract at $3.00. If corn goes up to $3.50, you would sell the contract and pocket $0.50 per bushel profit. If corn went down to $2.50, you'd lose $0.50 per bushel. On the flip side, if you thought corn was going down, and you sold (shorted) corn at $3.00, if corn went down to $2.50, you'd make $0.50 per bushel profit and if corn went up to $3.50, you'd lose $0.50 per bushel.

Futures contract if held till expiration would obligate you to "sell to" or "buy from" the counter-party the underlying asset. So, let's say you bought corn at $3.00 and corn went to $3.50 and you actually held it till it expired, you would then be obligated to purchase the corn at $3.50 (1 contract is 5,000 bushels, so you would have to pay out $17,500 to purchase the corn. Since you bought the corn at $3.00, you would have seen a $2,500 profit on the futures contract, thus offsetting the total cash outlay). So, yes, you would take delivery or make delivery (depending if you were long or short) of the underlying asset ONLY IF YOU HELD THE CONTRACT TILL EXPIRATION. And these pictures you see of bushels of corn or wheat being dumped in a persons yard is bogus. The asset is delivered to you in the form of warehouse receipts.

So, in reality the only people that hold futures contracts till expiration and producers and end-users of the underlying asset. Individual speculators make their money off of price fluctuations in the contract; they sell or rollover their contract prior to expiration.

Hope this helps.

Answer 6

What are you talking about???