It seems like just about every day recently, news services have been barking about oil prices going up. "Record breaking" keeps showing up in the news copy. In a
CNN Money article for August 9 was the following somewhat cryptic line: "Light, sweet crude for September delivery fell 87 cents to $63.07 a barrel..." At least the word "fell" was in there, so that might be good news; but what's with the light and sweet stuff, and what's with September when it's still August? Well, the "light, sweet" just refers to a grade of oil, and that's how trading is done with most contracts: each identifiable grade of a product gets its own consideration based upon its characteristics. When Treasury bonds trade, they trade based upon their maturities; when currencies trade, each trades based upon the nation issuing the currency; et cetera. But that doesn't explain the September part, which has to do with the fact that these news reports are discussing futures
contracts, and it is these animals that will be explained in a simplified manner below.
Before we get started, keep in mind that this is a very basic introduction to what futures contracts are all about. A little bit of terminology is introduced, and the underlying purposes for futures markets are shown. Those intimately familiar with futures will find all kinds of oversimplifications in here and will have reason to sharply criticize the example used as being unrealistic. To those critics, I acknowledge the complaints, and in the spirit of fraternal comraderie I say, "Bite me."
Let's take that simplified tour of a few basics about futures contracts.
You are Henry Hineyswilt, and you are planning your traditional Halloween festival. You'll be needing a thousand pounds of pumpkins in about the third week of October. Now, it so happens that you know a guy named Lester Longsteam who will have more than enough pumpkins to fill your order. Right now, pumpkins are selling for 25¢ a pound. This is what we call the spot
price of the pumpkins. You obviously don't need the pumpkins right away, so you would like to buy a forward contract
: an agreement that specifies a price, quantity, and terms of delivery for some date in the future. Well, as it turns out, pumpkins are such a popular commodity
that there is a standardized
contract for them: there's an agreement for each month of the year; it states the number of pounds in a delivery and where the delivery is to take place. When a market is such that completely standardized forward contracts are available, we say there's a futures market
, and the contracts are called futures
. Everybody knows the terms of these agreements, and there's no need for buyers and sellers to meet face to face to hash out how much, where, and when. It's all there, laid out in these perfectly standardized, off-the-shelf agreements.
Okay, then, you've never dealt in futures for pumpkins before, so you look into it. You discover, much to your satisfaction, that a pumpkin futures contract for October is open
, and each contract specifies delivery of a thousand pounds of pumpkins on the 15th
of the month at the Farmers' Market just outside of Peoria. You figure this is going to work out perfectly. You tell Lester to go ahead and sign you up for a thousand pounds of pumpkins, and you get ready to give him a check for 25¢ per pound times 1000 pounds, or $250.00. Lester says to you, "No, Henry, I don't want to do a plain forward contract with you; I want you to go long
one futures contract. I'll write
(that is, 'I'll go short
') a futures contract. We'll do this through the pumpkin futures clearinghouse
because they deal in millions and millions of futures every day, and they guarantee payments and deliveries." You think this is a little strange, but you agree. Much to your surprise, when you buy the contract from your local pumpkin futures broker, Karl Korkburt, he tells you that you'll need to give him a check for $25
, not $250! You ask him why you're not supposed to give him the whole amount, and he says, "Sir, all you pay on a futures contract is the margin
, which in this case is 10%. You're not taking delivery now, so why would you pay the whole amount now?"
This makes sense to you, and you're about to tell him to go ahead, when he says, "Oh, wait a minute! My bad. I just quoted you the spot on pumpkins: that's
going off at $250. Let me see what the futures
prices are." You hear him clicking his keyboard, and then he says, "Okay, the September contract is going off at $230, and the October is going off at $190."
You find this odd, so you ask him to explain why these futures prices are less than the spot price. He says, "Well, first of all, money in the future isn't worth as much as money now. That's true for all instuments where money changes hands down the road instead of right away. But more importantly, traders by the millions are dealing in these pumpkin futures, and it is their judgment through their collective trading that there will be more pumpkins available in September, and lots
more available in October. That means spot prices then should be lower than they are right now, when pumpkins are in pretty short supply."
Suddenly, it hits you: instead of paying the spot price to some producer for delivery in October, the futures contract allows you to pay what the market is currently assessing the price of those pumpkins will be in October
, when you want delivery!
This is great, you figure. You authorize Karl to go long one pumpkin futures contract, and you give him the $19.00 (plus his commission, of course).
Well, the next day, Karl calls you and says you need to send him a check for some more money. You say, "I just sent you the $19 plus your commission, fool"; and he responds by saying, "Yes, but the October pumpkin futures contract is now trading at $180 (in other words, 18¢ per pound on the pumpkins). You say, "Yeah... so?" He gives an exasperated sigh and says, "You need to cover
, Henry. Yesterday, you were holding a contract that obligated you to accept delivery of pumpkins at 19¢ per pound. Today, those October pumpkins are worth only 18¢ per pound. You've lost money: you had $19 margin with us; you lost $10 on the contract, so that puts you at $9; your margin on the new, $180 price is $18, so we need another $9."
This annoys you a little, and it doesn't exactly make sense; but then you say to him, "So, what would have happened if the price of the October futures contract had risen to $220?"
He answers, "Then your contract would have been worth more than you paid for it, so the gain would have gone into your cash account with us: you had the original $19 margin money, and you gained $30 on the contract; with a $220 price, your new margin would be $22; but with $49 in the account, you'd have $27 clear."
Ah, so this is how it works. You're making or losing money every day on the contract. Unlike stocks, bonds and other such financial investments where you don't actually realize
gains and losses until you liquidate a security, futures trading means rising and falling real cash balances in your trading account every last day that your position is open. It strikes you that this means, if you're some kind of big-time trader in pumpkin futures, your net position could be whipsawing back and forth pretty seriously, so you'd have to have serious cash at the brokerage to cover in case the price went severely against your position.
You think you've got it all straight in your heart, and it's now the early part of October. The September contract has already expired, so October is the front-end
contract. Everything is cool until you hear some awful news. The state in which you reside has just passed a law banning Halloween celebrations because they honor pagan religious beliefs contrary to the Judeo-Christian principles upon which this great nation was founded. If you were to go through with having that Halloween party, the maximum penalty would be $750 and death by burning at the stake. You call all your friends and tell them to forget about Halloween; you'll have some kind of Thanksgiving Day affair complete with proper and earnest prayers that the religious nuts all get zapped up to Heaven by Christmas so you won't have to buy them any presents. You also call the costume rental store and cancel your order for that Casablanca/Rocky Horror Picture Show combo outfit, and you kill the order at Sam-the-Spam-Man Catering. Problems solved.
Suddenly, something occurs to you: you have agreed to accept delivery of one thousand pounds of pumpkin pursuant to an open
futures contract! You panic. You run around trying to figure out what to do.
Finally, you call that pumpkin broker, Karl Korkburt, from whom you bought the futures contract. He just starts laughing: "Sir, there's no reason for you to be acting like this. All you do is close the position
." You ask him how to do this, and he says, "You simply take exactly the same position on the opposite side." After he checks his open positions screen, he says, "I remember: you're long one contract. That means, to close your position, you need to write
You respond, "Now wait a minute, Karl. You're telling me that I am now going to agree to accept delivery of a thousand pounds of pumpkins, and at the same time I'm going to agree to deliver
a thousand pounds of pumpkins. What a fiasco!"
Karl has about had it with you by this point. "No, you ignoramus. The clearinghouse will see that you're long one October contract and short one October contract, so your net position is flat. You're out of the game. You're done. It's over."
A little sheepish at knowing so little, you grunt, "I'm done if I just write a contract, now?"
"Yes sir. As long as it's the same one you're long," Karl answers, getting his cheesy good humor back.
"Oh, well, let's do that, then," you tell him. "And let me know what this is going to cost me."
The broker says, "Well, I see that, as of yesterday, the price was $220 on the front-end contract. You had $30 in your account. Today, it looks like the price is up to $225, so we're going to have you write an October at that price."
You get all kinds of curious. You say, "I went long at $190, and yesterday it closed at $220, and that means I've got $30 in cash right now. So what happens here?"
The broker says, "Well, you're holding a contract that was marked
at $220 as of last night; and you're going to write one that will sell at $225. That means you're five bucks ahead for the day and for the termination of the position, so that five dollars will add to your $30, so you finished the game ahead with a net gain of $35."
You grumble, "God, this is complicated."
Karl chuckles and responds, "No, it's complicated only because you were thinking about it the wrong way all along. You see, Henry, you kept thinking that you owned a contract you bought back in August; but you really shouldn't have been thinking that way. What was really happening was that, at the end of every day, your position was being closed out, and your gain or loss was being calculated, and the real wins or losses were going into or coming out of your account. Unless you did something about itwhich you never did until this very minuteyour position was being re-opened at the new price the next morning exactly as that position had been configured when the market closed the day before!"
"Ah!" you roar. "That's why I'm making only five dollars today: my position opened this morning by me automatically, without my doing anything, purchasing an October contract at $220! And now, because the price has gone up to $225, I'm ahead five bucks for the day
"BINGO!" Karl crows. "Whatever happened to the price of the October contract in previous days was already settled in your account. That money's already been there."
And you chime in, "But what really happened was that hundreds of dollars was going in at night, and then hundreds of dollars was heading back out in the morning."
"Well, I wouldn't say 'hundreds of dollars,' Henry," your broker corrects. "You're a small-time player, and you were working with margins that weren't even a drop in the bucket."
Now, you get curious. "Tell me this, Karl: if I hadn't thought to call you to kill this open position, would I really have had a thousand pounds of pumpkins show up at the shipping yard in Peoria?"
"No," your broker answers, "the clearinghouse keeps that from happening. Even though you were using futures to hedge
meaning that you were one of those types who actually had pumpkins or wanted pumpkins and were using contracts to guarantee a future delivery priceyour position would have automatically and permanently closed on the closing date of the October contract, and you would have to have purchased the actual pumpkins, themselves, in the spot market with the proceeds from the liquidation of your futures portfolio for October. If you think about it, once the October contract has reached its end on the last day of trading before deliveries specified in the contract, the position couldn't
be opened again the next morning because the October contract would no longer exist."
"I see," you ponder. "But I just got the impression from something you just said that there are people who do this who aren't really trying to buy and sell pumpkins."
"That's right, Henry," the broker agrees. "We call them speculators
; they play these markets for pumpkins, for oil, for hog bellies, for currencies, for interest rates, and for all kinds of other things just to try to make money from day to day."
You kind of laugh and mumble, "Those speculators aren't trying to control
risk; they're actually taking
"You're exactly right!" Karl hollers. "Hedgers are simply establishing a known price they'll end up paying out in the future. They're not interested in winning or losing on price swings. If you'd actually had to buy those pumpkins you were planning to, you would have ended up paying the $225 spot for them at a farmers' market. The futures contract made you some extra money that would have then gotten eaten up when you went and bought the commodity. Speculators aren't playing the game to hedge risk of real products they're buying or selling; they're just trying to make a buck off the price swings."
"So they're like parasites," you declare.
, Henry," your broker protests. "They are critical to the price discovery
function of the market for a commodity. They're doing research, analyzing trends, studying patterns, and pounding out real leg work on the underlying commodities; so their buying and selling pressures on the prices are just adding more critically important information that helps the prices of those futures contracts reflect the best possible overall market assessments of future pricing conditions."
"Yeah, whatever," you grunt. "They've got more guts than I have. The way those futures contracts can make your net account position swing back and forth from positive to negative every day is enough to give a person a stroke. I can't imagine doing that with hundreds of open contracts every day."
"Well, some people can handle that, Henry, but I'll tell you this: futures are no place for beginners to start their careers; but they've sure been the place where a lot of folks have gotten their careers ended."
And with that, you bid farewell to Karl, hang up the phone, and thank your lucky stars that your days as a futures trader are over. Now all you have to worry about in this world is having the state authorities find out that you had been actively planning a pagan ritual. Just be glad that you didn't actually go through with the Halloween party. Being burned at the stake is almost as bad as being burned by futures trading.
The Dark Wraith has spoken.