3) Futures Fundamentals: How the Market Works
The futures market is a centralized place where buyers and sellers all over the world can meet and enter into futures contracts. Pricing can be in the form of an open cry system or electronic bids. The futures contract will name the price to be paid and the date of delivery.
What is a Futures Contract?
Suppose you want to include text messaging in your mobile phone contract. You enter into an agreement with a mobile phone operator for a specified number of text messages each month at a set price throughout the year. This is similar to a futures contract where you agree to receive a product at a given date, with the price and terms of delivery already specified. The price is therefore secured from the time you enter into an agreement until the next year even if the price of text messaging rises during that time. With this type of agreement, you have reduced the risk of higher prices.
Now imagine we have a producer of, for example, corn, trying to secure a selling price for next season’s harvest and a cereal company trying to secure a buying price to determine how much corn can be made and the accompanying profit. With this, the farmer and the cereal company may enter into a futures contract for the delivery of 7,000 bushels of corn to the buyer in June for $5 per bushel. With this contract, the involved parties will secure a price that both believe to be fair. Take note that it is the contract and not the actual corn that is being bought and sold in the futures market.
A futures contract is therefore an agreement between two parties. One is a short position, or the party who delivers the commodity good and the other a long position, or the party who receives the good. In this case, the farmer would be in the short position and the long position would be the cereal company.
Everything is specified in the futures contract such as the quantity, quality, price per unit, date of delivery and method of delivery. The price that we call here is the agreed-upon price of the good or financial instrument that will be delivered in the future. For this example, the price of the contract is 7,000 bushels of corn at $5 per bushel.
Profit and Loss
The futures contract profits and losses are dependent on daily movements of the market and are calculated on a daily basis. Taking the farmer and cereal company as an example, suppose the futures contract for corn increases to $6 per bushel the day after they enter into their contract at $5 per bushel. The farmer would have lost $1 per bushel because the selling price increased from the future price at which he is obliged to sell his corn. On the other hand, the cereal company, profited $1 per bushel because the price in the contract is less than what is dictated in the market for wheat.
On the day the change in price happens, the farmer is debited $7,000 ($1 per bushel x 7,000 bushels) on his account and the cereal company gets a credit of $7,000 ($1 per bushel x 7,000 bushels). Adjustments like these are made accordingly as the market moves on a day-to-day basis. In the stock market, however, capital gains or losses from price changes aren’t realized until the investor decides to sell the stock.
Most deals in the futures market are made in cash and the actual physical commodity is bought or sold in the cash market. Cash and futures market prices have parallel movement to each, other such that in the event either party decides to close out their futures position, the contract will be settled. Again, in the farmer and cereal company example, if the contract was settled at $6 per bushel, the farmer would lose $7,000 on the futures contract while the cereal company would profit $7,000.
However, after the settlement of the futures contract, the cereal company would still need corn to make cereals so it still has to buy corn in the cash market for $6 per bushel as this is the price in the market when the contract is closed. On the other hand, the farmer upon closing out his contract may sell the corn at $6 per bushel but as he has incurred a loss from the futures contract, he still actually receives only $5 per bushel. This would mean that the farmer’s losses are offset by the higher selling price in the cash market, which is called hedging.
Importance of the Futures Market
Price Discovery: The futures market has become a highly important economic tool to determine prices based on the current and future estimated supply and demand. This can be attributed to its highly competitive nature. Futures market prices need a high amount of transparency as it is dependent on a constant flow of information from all over the world. Various factors such as war, weather, debts, and etc. can have a major impact on supply and demand, thus affecting the present and future price of a commodity. The process by which this information is absorbed and the way people react to it can change the price of a commodity and is called price discovery.
Risk Reduction: So called such because risks are reduced as the price is pre-set, letting participants know how much they will need to buy or sell.