Basics of Speculating in the Futures Market

Most people have heard about trading on the Futures Market, and equate it with unscrupulous speculators who do nothing but drive up the price of things to earn large amounts of profits.  But is that really the case?  I will try to explain Futures trading so that the reader can understand the basics.

The Futures market is a strange place where it is possible and the rule to buy commodities that you don’t want, and sell things you don’t have.  For instance, anyone can take out a contract to deliver 10,000 bushels of soybeans in December.  The catch is, you have to buy 10,000 bushels of soybeans before your contract becomes due, or you are in trouble.

The object of Futures trading is to predict what the spot price (real price of the physical commodity) will be on the date the Futures contract becomes due.  The person who can do this will be able to profit.  The one who cannot will lose.

Futures trading has little to no long term impact on the real price of commodities.  This should become clear as you read this because: A) No additional real commodity is placed on the market, and B) No additional commodity is removed from the market.  Therefore, supply and demand remain unchanged regardless of the Futures price.

The value of a Futures contract becomes closer and closer to the spot price of a commodity as the delivery date becomes closer.

So how does someone make money from trading Futures?  Lets say its now June, soybeans are currently trading for $4.00 per bushel, and Futures contracts for December delivery of soybeans is currently $4.25.  Ken believes there will be a shortage of soybeans because of weather this year, so Ken will take out a Futures contract to buy soybeans at $4.25 per bushel.  As time passes, and crops yields are coming in below normal, the Futures contracts are going up in price.  Now into late November, contract prices for December delivery are $4.75, so Ken now takes out a Futures contract to sell soybeans at $4.75 a bushel.  Ken now has a contract to buy soybeans at $4.25 per bushel in December, and a contract to sell soybeans at $4.75 per bushel at the same time.  These two contracts cancel each other out, and Ken has just made $5,000 buying and selling soybeans he neither had nor wanted because he accurately predicted that the price of soybeans would go up.

Of course, Ken could have been wrong, the price of beans could have dropped, and Ken would have had to sell his beans at less than the $4.25 he paid for them, thus losing his investment.  In every transaction, there will be a winner and a loser.

If a trader thinks the price will go up, he buys now and sells later at a higher price.  If the trader thinks the price will go down, he sells now and buys later.  If he is right, he wins; if he is wrong, he loses.

Futures trading is done on margin, which means the full value of the contract is not paid when the contract is purchased.  Instead, a fraction of the cost of the commodity is paid into a trading account, and everyday, the gains or losses are posted.  So, if the margin is 10%, and the contract is for 42000 gallons of heating oil, the margin amount would be $8,400 if the price of oil is $2.00.  If the contract is to sell that amount of oil, and the price goes up 10 cents, then $$4,200 would be added to your trading account on that day.  If it dropped by 10 cents, then $4,200 would be deducted from your trading account.  You can see that small fluctuations can reap big rewards, or big losses for the trader.  This is done daily, and is referred to as “mark to market” accounting, and is done to protect the trading house against any losses.

For speculators, this is a game, in the fullest sense of the word, and the profits and losses are shared among the speculators.

In my next article, I will explain how the futures market is used by producers and consumers to hedge against fluctuations in the market.

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