13.1: Futures Contracts

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So what did you think about options, eh? Ready to start gambling, oops!, I mean, speculating with stock options contracts? Well, Dear Students, as the saying goes, “You ain't seen nothin’ yet!” The amount of money that you can lose speculating with futures contracts is staggering. However, unlike options, futures actually do have a very important usage in the global financial system ... for large producers and consumers of commodities such as wheat, oil, and pork bellies. (The last one being used for comedic effect in the 1983 movie Trading Places. Pork bellies, Dear Students, are what they make bacon out of.) For the rest of us, we are best served by staying away from these “Weapons of Mass Financial Destruction.” (This is a phrase coined by famed investor Warren Buffett.)

What Are Futures Contracts?

A futures contract is a commitment to deliver a certain amount of some specified item at some specified date in the future. A futures contract buyer and a futures contract seller specify a commodity or financial instrument to be delivered and paid when the contract matures. The futures price is guaranteed by the contract. Futures contracts started with commodities, also referred to as hard assets or real assets. Examples include wheat, soybeans, cattle, pork bellies, gold, silver, copper, oil, and gas. However, there are now futures contracts that cover financial assets such as stocks, bonds, and currencies.

Commodities Futures Contracts

Producers of commodities use futures contracts extensively. For example, a wheat farmer in Iowa plants 1,000 acres of wheat in April. He knows that if all goes well, Lord willin’ and the creek don’t rise, come September he will have 50,000 bushels of wheat. September wheat futures are currently selling ‒ in April! ‒ for $6 per bushel. Our farmer can “sell” his wheat via a wheat futures contract while it is still germinating in the ground. He can guarantee a price that he is happy with and will result in a profit for him. The contract states he will deliver the wheat in September and receive $6 per bushel no matter what happens to wheat prices.

Consumers of commodities also use future contracts. For example, cereal companies such as Kellogg’s, General Mills, and Post Cereal need tons and tons of wheat each year to make cereal and other foodstuffs. Via futures contracts, in April, they can purchase the wheat to be delivered in September and pay $6 per bushel no matter what happens to wheat prices. In this way, we can think of futures contracts as insurance. The farmer and the food companies are using futures contracts like insurance to protect themselves.

Can you see the rationale behind these instruments? Futures contracts allow producers and consumers of commodities to hedge. Hedging is taking a futures position opposite to an existing position in the underlying commodity or financial instrument. “Hedge your bet!” Have you ever heard this saying? The farmer will have tons of wheat so he is taking a position opposite to his holdings; he is selling his wheat. The food companies will need tons of wheat so they are taking a position opposite to their need; they are buying wheat.

What are the disadvantages of using futures contracts when you are the producer and when you are the consumer? If wheat prices plummet, the farmer is protected, yes, but on the other hand, if wheat prices rise substantially, the farmer cannot take advantage of the higher prices since he is already contractually obligated to sell his wheat for $6 per bushel. Likewise, although the food companies are protected against considerable price increases, if prices fell appreciably, they will not be able to take advantage of the lower prices since the food companies have already promised to pay the farmer $6 per bushel, no matter what happens to wheat prices.

Here is a list of common commodities:

Food and Fiber	Livestock and Meat	Forest Products	Precious Metals
Barley	Feeder Cattle	Hardwood Pulp	Gold
Canola	Lean Hogs	Lumber	Palladium
Cocoa	Live Cattle	Softwood Pulp	Platinum
Coffee	Pork Bellies		Rhodium
Corn			Silver
Cotton
Flaxseed	Energy	Metals	Other
Milk	Brent Crude	Aluminum	Amber
Oats	Electricity	Aluminum Alloy	Palm Oil
Orange Juice	Ethanol	Cobalt	Rubber
Rapeseed	Gulf Coast Gasoline	Lead	Wool
Rice	Heating Oil	LME Copper
Soybean Meal	Natural Gas	LME Nickel
Soybean Oil	Propane	Molybdenum
Soybeans	RBOB Gasoline	Tin
Sugar	WTI Crude Oil	Zinc
Wheat

Financial Futures Contracts

The financial world adopted the technique of futures contracts to financial assets, treating financial assets like commodities. Financial futures contracts work similarly to commodities future contracts. Examples include currencies, interest rates, stock and bond indexes. “I will deliver $25,000 worth of British Pounds to you next April.” “I will purchase $10,000 worth of the S&P 500 stock index from you next August.”

For those working in the World of Finance and especially, the World of International Business, financial futures contracts can be very useful tools. For example, a car manufacturer based in the United States knows it will need to purchase 50,000 engines from Japan next October. The manufacturer can buy a currency futures contract for $30,000,000 worth of Japanese Yen payable in October. This protects the manufacturer from adverse currency fluctuations. Again, we can use the analogy of insurance. The manufacturer bought insurance against the United States dollar falling relative to the Japanese yen. If the dollar does fall relative to the yen, the manufacturer is protected. If the dollar rises against the yen, the manufacturer bought insurance that they did not need.

Speculating with Futures Contracts

Can anyone buy futures contracts? Lucky You! You do not have to work in either the commodities world or the finance world to buy and sell futures contracts. You can be a speculator! You simply buy and sell the futures contracts. You never actually deliver or take delivery of the commodity nor the financial asset. You could buy the 50,000 bushels to be delivered in September even though you live in a condo in West Los Angeles and have never even seen a farm!

Speculating with futures contracts is accepting the futures price risk without having a position opposite to an existing position in the underlying commodity or financial instrument. It is the opposite of hedging. One boring Introduction to Investments textbook said, “… futures speculation is risky, but it is potentially rewarding if you can accurately forecast the direction of future commodity price movements.” Can anyone accurately forecast the future? If our LA speculator sitting in her condo had purchased the futures contract for 50,000 bushels of wheat to be delivered in September and wheat prices plummeted, she could potentially lose hundreds of thousands of dollars!

Note: When and if you ever start speculating with futures contracts, your broker will be watching your account like a hawk. They will do their best to make sure that you never get close to losing hundreds of thousands of dollars. Why? Because if you disappear and send them a postcard from East Jabip, the brokerage firm is required to make good on the transactions. If you start to lose too much money, they are permitted to close you out of the transaction, even if you will lose a substantial amount on the deal. We will discuss this in detail in our next chapter.

Final Characteristics and Comments on Futures Contracts

The largest, most active futures exchange is the Chicago Board of Trade although futures contracts are traded on many other exchanges. The “long position” is the buyer of the futures contract and is protected from futures price increases. In our example, these are the cereal companies, Kellogg’s, General Mills, and Post Cereal. The “short position” is the seller of the futures contract. The seller is protected from future price decreases. In our example, this was the farmer. We will discuss the term long and short in detail in our next chapter.

Futures contracts seem similar to options contracts. In fact, the two are very similar. Financial futures work very much like options. There is the potential for great rewards but there is also much more of the likelihood of sustaining great losses. In fact, the potential losses from futures contracts are staggering! And, just like options, they are a tremendous source of commissions for your broker. Oh, by the way, you can purchase options contracts on futures contracts. What do you think about that?

Our final comments on futures contracts?

STAY AWAY FROM THEM!

They are even more potentially dangerous than options. Here is an article about how hapless would-be speculators lost tremendous amounts of money in the world of futures contracts. If you search for other examples using an Internet search, unfortunately the numerous advertisements for how to teach you to get rich quickly “investing” in futures crowd out the articles trying to warn you about their dangers.