Futures Futures are binding contracts that involve risk, and are time bound Unlike options, they are the obligation (not right) to buy or sell an underlying asset (commodity, index, bond or currency) at a pre-set price on a specific date Commodities – precious metals  Gold, silver, copper Commodities – consumable  Wheat, oil, soybeans, corn, rice

Futures Complexity Unlike options, futures have complexity based on:  Weather – will the crop be as big as forecasted  Quality – will the crop freeze?  Delivery – even if the crop fares well, can I deliver it timely? Margin  While you have to be approved to trade options, you need to have a margin account to trade futures  The initial margin deposit is usually 10% of the contract  Contract for $35,000 requires a deposit of $3,500 Nearly 98% of futures contracts are sold before expiration – physical delivery rarely occurs

Who Uses Futures? Hedgers and Speculators Hedger  Producer of the commodity, such as a farmer or oil company  Users of the commodity, such as a jeweler, bakery, energy distributor  Hedgers are protecting their profit margin Speculator  Professional traders looking to make money off the contract  Try to predict the direction of the market so they can profit from the spread between the cost and sale of the contract

Hedge Example: Textile Company August – company buys 100 December cotton futures representing 5 million pounds of cotton at $0.58 per pound Cotton crop fails, reducing supply. Price shoots up December contract now trades at $0.68 Company can take physical delivery of cotton at $0.58, which is $0.10 less than the market price Company reduced its risk and saved $500,000 ($0.10 on 5 million)

Speculators create a market to reduce risk for users of a commodity If they weren’t willing to speculate, there would be no market Speculation leads to higher prices Example: The Real Estate Market  Investors bought properties for investments purposes, not to live in  They expected to sell them at a higher price  They often put no money down and used interest only mortgages, thinking they were going to sell and capture the price appreciation  When values plummeted, investors dumped properties they had no equity in  This drove prices down because there was excess supply

Zero Sum Game Futures are not like stocks, bonds or options  Your gain is someone else’s loss  They are more volatile  Because you are always working with a margin position (borrowed money), your risk is greater than with an option  There is no periodic payment, like a bond would have  There are no dividends, like a stock would have

Hedge Against Price Change For example, let’s assume cash and futures prices are identical at $9.00 per bushel  What happens if prices decline by $1.00 per bushel? Although the value of your long cash market position decreases by $1.00 per bushel, the value of your short futures market position increases by $1.00 per bushel Because the gain on your futures position is equal to the loss on the cash position, your net selling price is still $9.00 per bushel.

Hedge Against Price Change