Introduction
Most investors have heard about futures contracts, but few can tell you what they are. The reason most investors know so little about them is because they’ve most likely only heard the misconception that futures are incredibly risky, that they could lose their entire investment in the blink of an eye, and that futures contracts are really only suited for out-of-control speculators. If this were true, then questioning why anybody would ever bother to learn about futures trading would seem to be valid.
But here’s a better question: Why futures contracts still exist? If it were really true that the futures markets are just legalized gambling arenas where investors are destined to lose money, then why have they persisted for so long? Why do investors use futures?
The reason it may seem contradictory for many of the world's best investors to use futures markets -- despite the publicized risk -- is that you've probably only heard part of the story. Any asset can be risky if it’s used the wrong way, and futures markets are no exception. Credit cards are a good example -- they can cause serious trouble and also be a lifesaver with equal ease; it all depends on how they are used.
In 1995, Nick Leeson single-handedly bankrupted Baring's Bank, one of the world's largest banks at the time, by creating a 1.3 billion-dollar loss using futures markets to speculate on the direction of the market. In June 2002 John Rusnak, a currency trader for Allfirst Bank, scored a $691 million-dollar loss using options on futures. It is easy to jump to the conclusion that we should do away with futures markets after hearing sensational stories like these.
However, at the time of these bank catastrophes, Kellogg cereal, Coca-Cola, Ford Motor Company, and nearly any other major company you can think of also used futures contracts. But rather than speculating on currencies or the direction of the stock market, they used them to lock in profits and remove unwanted risk from their production. In doing so, they also created lower and more stable prices for all countries in which they conducted business. We would live in a very different world if futures contracts did not exist. Are futures contracts good or bad? It all depends on how they are used.
The fact is that futures markets are the most cash-efficient way to invest, which is a benefit the professionals have enjoyed for years. Futures also provide for greater portfolio diversification, custom-tailored assets, and quicker executions. They are even exempt from the "uptick" rule if you wish to "go short," which makes them a truly flexible and powerful asset that cannot be matched, in many respects, by any other.
Single-Stock Futures
Many investors avoid learning about futures contracts because they are typically traded on pork bellies, heating oil, wheat, and other commodities in which most of us have no reason, or desire, to invest. That all changed, as futures contracts on individual stocks -- single-stock futures -- have been trading since November of 2002. Rather than trading futures contracts on pork bellies, euros, or mixed xylenes, you can now trade futures contracts on individual stocks such as Intel, Microsoft or many others. While not all stocks have futures contracts on them, most of the major names you know eventually will. If you want all of the benefits the professionals have enjoyed for years and you are an avid investor or speculator, it will pay to understand futures.
This course will take you by the hand from the very beginning. We will give you simple examples of futures contracts, work up to real commodity contracts, and then bring you up to speed with single-stock futures. You'll understand everything you need to know to be comfortable placing your first trade.
For now we just ask that you forget about every negative thing you may have heard about futures and approach this course with an open mind. And no, this doesn't mean we're going to cast futures in a "no-risk" light. Sure, there's risk -- we will expose that too. We just want you to approach the course with an unbiased mind so that you can see the benefits -- as well as the risks -- and make an informed choice as to which strategies, if any, are best for you.
If you do, you will gain knowledge that will greatly change your perception of investing.
What Is a Futures Contract?
The name "futures contract" sounds puzzling and can certainly make many investors think that they are much too complicated to use in a personal investment portfolio. The fact is they are very easy to understand and are beneficial to everyday consumers. In fact, I'm fairly sure you've used futures contracts already! Now, you may not have used a bona fide futures contract, but I'm pretty certain you've used some form of one. Let's look at the definition of a futures contract and then see how you may have used them:
Definition: A futures contract is an agreement today to buy or sell something in the future at a predetermined price. |
That's all there is to it. If you agree today (a contract) to buy or sell something at a later date (the future) at a price that is also agreed upon today, that's basically a futures contract. Think about that definition and how you may have made similar agreements. Probably the simplest form is a layaway plan you may have used at a local department store. Say you wish to buy a big-screen television for someone as a Christmas gift. One day you find the perfect one on sale -- the bad news is that it's only September. If the store allows you to put it on layaway, they agree to sell it to you in December at today's sale price. No matter what happens to the prices between now and then, your purchase price is guaranteed. You will probably be required to place a small amount of money down as a "good faith" deposit, and then they will store the television for you until it is time to pick it up. At that time, you will be required to pay for the full amount and can then take delivery.
Think about why you might use layaway. First, you may not have the money today but will have it at the time of delivery. Using layaway can be a way of deferring a payment. Second, you may be afraid of the price rising. Using layaway locks in your purchase price. Third, you may not have the space to hide the thing until December and layaway allows for someone else to store it for you. These are all valid reasons for using commodity futures, with the primary reason being that of locking in the purchase price.
Now think about why the store allows layaway. While they did not sell you a television today, they have guaranteed themselves a sale in December, which is certainly better than no sale at all. Also, while layaway protects you from rising prices, it protects the store from falling prices. It is certainly possible that television prices fall and the store receives less money in the future. Using layaway allows the store to move inventory and lock in profits.
 | Key Points |
- For the store, the layaway plan (futures contract locked in profits
- For you, the layaway plan (futures contract) controlled costs
Let's examine some other forms of futures contracts you may have used. Have you ever contracted with a builder to have a home built? If you did, you may, for example, talk to a builder and agree to pay $200,000 in six months once the house is finished. You will likely be required to put a small amount of money down as a "good faith" deposit, but the real money will not change hands until completion. Once again, this is basically a futures contract.
Magazine subscriptions and C.O.D. packages are yet other forms of "futures contracts" you have probably used in the past
| Thought Questions: 1) If you wait for new cars to come in, what risk do you face? |
Think about these questions for a minute and then continue reading for the answer...
This is a great example of how "futures contracts" are used in everyday situations and one you've probably encountered. The fact that there are no cars on the lot should not prevent a dealer from selling you one -- he can simply enter into a futures contract with you. Although car dealers won't refer to these agreements as futures contracts, that's basically what they are. The salesman may say, "I don't have that car on the lot right now, but I can order one for you. It will arrive in about three months." If you agree, the salesman will require a small deposit, maybe as low as a couple hundred bucks, and have you sign an agreement saying that you will pay a certain amount for it when it arrives in three months. That's essentially a futures contract. You both agreed to buy and sell something today for a predetermined price but will not pay for it and take delivery until a later time.
In the introduction to this course, we mentioned that futures contracts have a reputation for being very risky. If that is true, then why does this example seem to make so much sense? Why would anyone do such a "speculative" and "reckless" thing as enter into this futures contract with the dealer? Hopefully you see that it's not speculative in this case. You wanted the car today but the dealer did not have one. If you wait for three months for the next shipment to arrive, you are running the risk of prices moving higher (after all, the fact that he is sold out suggests that there is excess demand and prices may rise). By signing the contract and placing a small deposit, you are locking in your purchase price and have removed all unwanted risk of higher prices associated with waiting for the new cars to arrive. At the same time, you will not benefit if the car price should fall, but that obviously was not a concern of yours; otherwise you would not have signed the contract.
The car dealer, on the other hand, faces the opposite set of risks. The dealer is at risk if prices fall (or if you go somewhere else to purchase), so he wants to guarantee the sale today and lock in his profits. It is important for you to understand that the futures contract is made possible because each of you faced opposite risks: You faced the risk of rising prices and the dealer faced the risk of falling prices. Entering a futures contract with the dealer allows you to control costs and allows the dealer to lock in profits.
| Key Point |
One of the key elements in making a futures contract work is that both parties face opposite sets of risk. The buyer faces the risk of rising prices while the seller faces the risk of falling prices.
Futures contracts were designed to remove unwanted risks associated with unforeseen future events. They exist for the very reason your car dealer and you are willing to lock in a price today for delivery in the future. If that sounds like a good thing, then maybe futures contracts are not such a bad idea. In fact, as you learn more, you will probably agree that the futures contract is probably the most important and successful financial innovation ever.
Maybe there is a way for you to use them in your financial portfolios after all?
Futures and Forwards
We said the previous examples were "basically" futures contracts. Why aren't they considered a real futures contract? The reason is purely technical. Futures contracts are exchange traded, like shares of stock, and are standardized as to the size and quality of the underlying asset.
The car example we just gave is really what's called a forward agreement since it is not a standardized contract traded on an exchange -- that car contract was privately negotiated by two independent people. The car dealer and you were completely free to set the delivery date, deposit amounts, and other contract specifications, which is a really nice feature about forward agreements. The bad thing about them is they are often illiquid, which means that if you must get out of your contract, you may have to take a substantially reduced price to get someone to buy it from you, assuming the contract is even transferable. With forwards, you're also at risk of default by the other party and you must make sure you're dealing with someone reputable who can "make good" on the contract -- especially if it moves against them. For instance, if the price of the car rises substantially, will the car dealer try to back out of the contract?
Futures contracts, on the other hand, are cleared through well-capitalized clearing firms, so there is no risk of default by the other party. The clearing firm becomes the buyer to every seller and the seller to every buyer. Futures contracts are standardized as to size, quality, delivery dates and all other contract specifications with one exception -- price -- which is left for the market to decide. Whether standardization is good or bad is a matter of debate, and there are certainly pros and cons to each side. Standardization is good in that it provides a lot of liquidity, but its not so good in that it creates inflexible terms. To understand what we mean by inflexible terms, take a look at the "random length lumber" contract at the Chicago Mercantile Exchange (CME). This futures contract is an agreement to buy and sell random lengths of 2x4s between 8 and 20 feet. According to the rules of the CME, the following box shows how rigorous they are in defining exactly what is a deliverable grade of lumber. The deliverable grades through May 2002 are described as follows:
| Deliverable Random Length Lumber For Contract Months Through May 2002 Each delivery unit shall consist of nominal 2x4s of random lengths from 8 feet to 20 feet. Each delivery unit shall consist of and be grade stamped CONSTRUCTION AND STANDARD, STANDARD AND BETTER, or #1 or #2; however, in no case may the quantity of Standard grade or #2 grade exceed 50%. Each delivery unit shall be manufactured in California, Idaho, Montana, Nevada, Oregon, Washington, Wyoming, or Alberta or British Columbia, Canada, and contain lumber produced from and grade stamped Hem Fir (except that Hem -Fir shall not be deliverable if it is manufactured in Canada; nor that portion of Washington including and to the west of Whatcom, Skagit, Snohomish, King, Pierce, Lewis and Skamania counties; nor that portion of Oregon including and to the west of Multnomah, Clackamas, Marion, Linn, Lane, Douglas and Jackson counties; nor that portion of California west of Interstate Highway 5 nor south of US Highway 50), Englemann Spruce, Lodgepole Pine, Englemann Spruce/Lodgepole Pine and/or Spruce Pine Fir (except that Spruce-Pine-Fir shall not be deliverable if it is manufactured in those portions of Washington, Oregon and California that are noted above). |
Inflexible to say the least, but on the other hand, the quality of the lumber will be consistent regardless of who is making the delivery. You may hear the terms forwards and futures from time to time -- just be aware that they are effectively the same thing. Futures contracts are just standardized forward contracts
| Thought Questions: 1) What is the main difference between a futures contract and a forward contract? |
Futures Are Not Options
Since we are talking about what futures contracts are, it may help to talk about what they are not. Investors new to futures often confuse them with options. While there are some strong similarities between futures and options, please be aware that they are two different assets used for different circumstances -- they are two different things.
On a similar note, both are a class of derivatives, which simply means their price is derived from an underlying asset. For instance, the price of the random length lumber contracts we talked about earlier will be derived from the price of the lumber market and the price of a Microsoft single-stock futures contract will be derived from the price of Microsoft stock.
Now, to complicate matters, there are such things as options on futures (which well talk about in a later lesson). However, futures contracts themselves are not options. There are several key differences.
First, with a long futures contract, you must buy the underlying asset at expiration, unless you enter an offsetting position. With a call option, you have the right, but not the obligation to buy the underlying asset. That's a subtle, but potentially big difference.
If a futures trader does not wish to take delivery of the underlying asset, he must enter an offsetting contract. An offsetting position is simply the purchase or sale of the same contract, which reverses your obligation. If you initially purchased a March futures contract, the sale of the same March futures contract is a reversing or offsetting position. Because futures use standardized contracts and a clearing firm to match up buyers and sellers, they provide a really big advantage over forward contracts by allowing a quick "escape" if you should desire to get out. Don't worry too much about this for now, as we'll be going further into detail a bit later on.
Compare this to a long call option owner. If a long call option owner wishes to not take delivery they simply do not exercise the contract, and there is no need to enter an offsetting position. Even if a long call is in-the-money by more than 3/4 of a point, a simple phone call to your broker can prevent the automatic exercise that otherwise would occur. Remember, with a futures contract you are entering into an agreement to either buy or sell the asset in the future. You are not entering into an agreement to give someone the option to do so.
Because the buyer of the option has the right and not the obligation to purchase the underlying asset, they must pay for this right by paying additional money over and above the cost of carry. For example, a one-year $100 call option will be worth at least $5 if interest rates are 5% since that is the foregone interest that could be earned on the $100. So that call option must trade for at least $5. However, we would likely see this call trading for much higher than $5, perhaps $12. While it is true that the option will lose the entire $12 in value if the stock is $100 or lower at expiration, it is the additional $7, in this example, paid by the option buyer that separates it from the futures contract. Again, futures contracts do not contain a time premium above their cost of carry, while options usually do. We'll expand on this topic when we examine the pricing of futures contracts.
Options provide limited downside risk, which is a really nice feature. But it comes at a price. That price is called "time decay," which simply means the option may lose significant value over time even if the underlying asset does not move (or moves in the wrong direction). This is not true for futures contracts.
A second difference between futures and options is that futures contracts will always have a value to them (please don't confuse that with profit). Options, on the other hand, will be worth $0 if they are out-of-the-money at expiration. Futures must have a value since you are entering a contract to buy and sell the underlying asset in the future. As we will show later, the futures contract must converge to the spot price (the price for immediate delivery) of the underlying asset at expiration. Only if the spot market became worthless will a futures contract be worthless at expiration. Futures contracts behave like very deep-in-the-money options.
Third, futures do not have strike prices like options do. If the underlying asset is trading for $100, you may see three -month options with strike prices of $80 through $110 in $5 increments. Whichever strike you buy, that just means you have the right, but not the obligation, to buy or sell the underlying asset for that strike price. Futures contracts, on the other hand, do not have strike prices. You cannot, for example, buy a March $100 futures contract. You could only buy the March contract. The price you agree to purchase the underlying asset is effectively your strike price.
Now that you've got the basic idea of what a futures contract is, it's time to move to the next lesson and take a closer look at how they actually protect the buyer from rising prices and the seller from falling prices.
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