___________________________________________________________________________________________________________ ____________________________________________________________________________________________________________________ P C M O F M O N T A N A 4 0 6 . 3 8 8 . 1 5 4 5 |
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THE FUTURES MARKET
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INTRODUCTION
What we know as the futures
market of today came from some
humble beginnings. Trading in futures originated in Japan during
the 18th century and was primarily used for the trading of rice and
silk. It wasn't until the 1850s that the U.S. started using futures
markets to buy and sell commodities such as cotton, corn and
wheat.
A futures contract is a
type of derivative instrument, or financial
contract, in which two parties agree to transact a set of financial
instruments or physical commodities for future delivery at a
particular price. If you buy a futures contract, you are basically
agreeing to buy something, for a set price, that is not deliverable
until a future date. But participating in the futures market does not
necessarily mean that you will be responsible for receiving or
delivering large inventories of physical commodities. Traders in the
futures market primarily enter into futures contracts to hedge risk or
speculate rather than exchange physical goods. The cash (spot)
market is where producers exchange physical goods. Futures are
used as financial instruments which to eventually tend to parralell
the price movement of the underlying cash market.
The consensus in the investment
world is that the futures market is
a major financial hub, providing an outlet for intense competition
among buyers and sellers and, more importantly, providing a center
to manage price risks. The futures market is extremely liquid, risky,
and complex by nature, but it can be understood if we break down
how it functions.
While futures are not for
the risk-averse, they are useful for a wide
range of people. A common denominator among all futures
contracts, is the need for hedging the underlying commodity.
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HISTORY
Before the
North American futures market originated some 150
years ago, farmers would grow their crops and then bring them to
market in the hope of selling their inventory. But without any
indication of demand, supply often exceeded what was needed, and
unpurchased crops were left to rot in the streets. Conversely, when
a given commodity, such as grain, was out of season, the goods
made from it became very expensive because the crop was no
longer available.
In the mid-19th
century, central grain markets were established and
a central marketplace was created for farmers to bring their
commodities and sell them either for immediate delivery (spot
trading) or for forward delivery. The forward delivery contracts were
the forerunners to today's futures contracts. In fact, this concept
saved many a farmer the loss of crops and profits and helped
stabilize supply and prices in the off-season. An important
distinction between forward contracts and futures contracts is
contract spefication. Specifications for all futures contracts for a
particular commodity are the same, except for price. Forward
contracts could have varying specifications, such as size, quality,
and delivery date.
As the agriculture
commodities dominated the futures markets for
over 100 years, financial contracts, such as foreign currencies,
treasuries, and stock indices were introduced in the 1970's and
1980's, and have dominated the futures industry ever since.
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HOW IT WORKS
The futures market is a
centralized marketplace for buyers and
sellers from around the world who meet and enter into futures
contracts. Pricing can be based on an open cry system, or bids and
offers can be matched electronically. The futures contract will state
the price that will be paid and the date of delivery. But don't worry,
as we mentioned earlier, almost all futures contracts end without
the actual physical delivery of the commodity
A futures contract is an
agreement between two parties: a short
position, the party who agrees to deliver a commodity, and a long
position, the party who agrees to receive a commodity.
In every futures contract,
everything is specified. The quantity and
quality of the commodity, the specific price per unit, and the date
and method of delivery. The price of a futures contract is
represented by the agreed-upon price of the underlying commodity
or financial instrument that will be delivered in the future.
Profit And
Loss - Open Trade Equity
The profits and losses of
a futures depend on the daily movements
of the market for that contract and is calculated on a daily basis. For
example, say the futures contracts for wheat increases 10 cents per
bushel the day after a trade is made. (Each cent change is equal to
$50.00).
On the day the change occurs,
the seller's account is debited $500
(10 cent x $50), and the buyers account is credited $500. As the
market moves every day, these kinds of adjustments are made
accordingly. Unlike the stock market, futures positions are settled
on a daily basis, which means that gains and losses from a day's
trading are deducted or credited to a person's account each day. In
the stock market, the capital gains or losses from movements in
price aren't realized until the investor decides to sell the stock or
cover his or her short position.
As the accounts of the parties
in futures contracts are adjusted
every day, most transactions in the futures market are settled in
cash, and the actual physical commodity is bought or sold in the
cash market. Prices in the cash and futures market tend to move
parallel to one another, and when a futures contract expires, the
prices merge into one price. So on the date either party decides to
close out their futures position, the contract will be settled.
A futures contract is really
more like a financial position. You can
see that the two parties in the wheat futures contract discussed
above could be speculators or hedgers. If a speculator, the profit or
loss is treated as a short-term capital gain. If a hedger, the gain or
loss would offset the change in value of the underlying physical
commodity.
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THE PLAYERS
Hedgers
Farmers,
manufacturers, importers and exporters can all be
hedgers. A hedger buys or sells in the futures market to secure the
future price of a commodity intended to be sold at a later date in the
cash market. This helps protect against price risks.
The holders
of the long position in futures contracts (the buyers of
the commodity), are trying to secure as low a price as possible. The
short holders of the contract (the sellers of the commodity) will want
to secure as high a price as possible. The futures contract,
however, provides a definite price certainty for both parties, which
reduces the risks associated with price volatility. Hedging by means
of futures contracts can also be used as a means to lock in an
acceptable price margin between the cost of the raw material and
the retail cost of the final product sold.
Speculators
Other market
participants, however, do not aim to minimize risk but
rather to benefit from the inherently risky nature of the futures
market. These are the speculators, and they aim to profit from the
very price change that hedgers are protecting themselves against.
Hedgers want to minimize their risk no matter what they're investing
in, while speculators want to increase their risk and therefore
maximize their profits. The speculator is vitally important as they
help provide the liquidity that the hedger needs.
In the futures
market, a speculator buying a contract low in order to
sell high in the future might be buying that contract from a hedger
selling a contract low in anticipation of declining prices in the future.
Unlike the
hedger, the speculator does not actually seek to own the
commodity in question. Rather, he or she will enter the market
seeking profits by offsetting rising and declining prices through the
buying and selling of contracts.
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REGULATION
The United States' futures
market is regulated by the Commodity
Futures Trading Commission (CFTC), an independent agency of
the U.S. government. The market is also subject to regulation by
the National Futures Association (NFA), a self-regulatory body
authorized by the U.S. Congress and subject to CFTC supervision.
A broker and/or firm must
be registered with the CFTC in order to
issue or buy or sell futures contracts. Futures brokers must also be
registered with the NFA and the CFTC in order to conduct business.
The CFTC has the power to seek criminal prosecution through the
Department of Justice in cases of illegal activity, while violations
against the NFA's business ethics and code of conduct can
permanently bar a company or a person from dealing on the futures
exchange. It is imperative for investors wanting to enter the futures
market to understand these regulations and make sure that the
brokers, traders or companies acting on their behalf are licensed by
the CFTC.
In the unfortunate event
of conflict or illegal loss, you can look to the
NFA for arbitration and appeal to the CFTC for reparations. Know
your rights as an investor!
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MARGINS AND LEVERAGE
Margins
In the futures
market, margin has a definition distinct from its
definition in the stock market, where margin is the use of borrowed
money to purchase securities. In the futures market, margin refers
to the initial deposit of good faith made into an account in order to
enter into a futures contract. This margin is referred to as good faith
because it is this money that is used to debit any day-to-day losses.
When you
initiate a futures position, the futures exchange will state
a minimum amount of money that you must deposit into your
account. This original deposit of money is called the initial margin.
When your contract is liquidated, you will be refunded the initial
margin plus or minus any gains or losses that occur over the span
of the futures contract. In other words, the amount in your margin
account changes daily as the market fluctuates in relation to your
futures contract. The minimum-level margin is determined by the
futures exchange and is usually 5% to 10% of the futures contract.
These predetermined initial margin amounts are continuously under
review: at times of high market volatility, initial margin requirements
can be raised.
The initial
margin is the minimum amount required to enter into a
new futures contract, but the maintenance margin is the lowest
amount an account can reach before needing to be replenished
back to the initial margin excess. For example, if your margin
account drops to a certain level because of a series of daily losses,
brokers are required to make a margin call and request that you
make an additional deposit into your account to bring the margin
back up to the initial amount.
Let's say
that you had to deposit an initial margin of $1,000 on a
contract and the maintenance margin level is $500. A series of
losses dropped the value of your account to $400. This would then
prompt the broker to make a margin call to you, requesting a
deposit of at least an additional $600 to bring the account back up
to the initial margin level of $1,000.
Word to
the wise: when a margin call is made, the funds usually
have to be delivered immediately. If they are not, the brokerage can
have the right to liquidate your position completely in order to make
up for any losses it may have incurred on your behalf.
Leverage
The Double-Edged
Sword
In the futures
market, leverage refers to having control over large
cash amounts of commodities with comparatively small levels of
capital. In other words, with a relatively small amount of cash, you
can enter into a futures contract that is worth much more than you
initially have to pay (deposit into your margin account). It is said that
in the futures market, more than any other form of investment, price
changes are highly leveraged, meaning a small change in a futures
price can translate into a huge gain or loss.
Futures
positions are highly leveraged because the initial margins
that are set by the exchanges are relatively small compared to the
cash value of the contracts in question (which is part of the reason
why the futures market is useful but also very risky). The smaller
the margin in relation to the cash value of the futures contract, the
higher the leverage. So for an initial margin of $5,000, you may be
able to enter into a long position in a futures contract for 30,000
pounds of coffee valued at $50,000, which would be considered
highly leveraged investments.
You already
know that the futures market can be extremely risky,
and therefore not for the faint of heart. This should become more
obvious once you understand the arithmetic of leverage. Highly
leveraged investments can produce two results: great profits or
even greater losses.
Due to leverage,
if the price of the futures contract moves up even
slightly, the profit gain will be large in comparison to the initial
margin. However, if the price just inches downwards, that same
high leverage will yield huge losses in comparison to the initial
margin deposit. For example, say that in anticipation of a rise in
stock prices across the board, you buy a futures contract with a
margin deposit of $10,000, for an index currently standing at 1300.
The value of the contract is worth $250 times the index (e.g. $250 x
1300 = $325,000), meaning that for every point gain or loss, $250
will be gained or lost.
If after
a couple of months, the index realized a gain of 5%, this
would mean the index gained 65 points to stand at 1365. In terms of
money, this would mean that you as an investor earned a profit of
$16,250 (65 points x $250); a profit of 162%!
On the other
hand, if the index declined 5%, it would result in a
monetary loss of $16,250--a huge amount compared to the initial
margin deposit made to obtain the contract. This means you still
have to pay $6,250 out of your pocket to cover your losses. The fact
that a small change of 5% to the index could result in such a large
profit or loss to the investor (sometimes even more than the initial
investment made) is the risky arithmetic of leverage. Consequently,
while the value of a commodity or a financial instrument may not
exhibit very much price volatility, the same percentage gains and
losses are much more dramatic in futures contracts due to low
margins and high leverage.
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