Reading & Viewing Assignments: Lesson 3

So, in this video, we're going to take a look at the futures market—basically the derivatives market, as it's called, which is made up of these things: futures, options, and covered warrants, which I cover in another video, and swaps, which I've also done in another video. Once you've got the hang of these three groups of products, you basically have all the planks required to understand derivatives.

So, what are futures? They're talked about in the context of commodities, indices, shares, and bonds. Let's start with the basic principles using a commodities-based example, and I'll use this example to illustrate all the key features. Bear with me if I use a little bit of artistic license in terms of the way the example works.

Okay, so let’s set up an example of forward contracts. Someone would use, first of all, something called a forward contract, because a future is just an exchange-traded forward contract. Forward contracts are very straightforward to understand. Most producers, most manufacturers, have a use for something in the forward market, and the reason is they worry about price. This is a way, basically, to take out price risk.

Okay, so let’s see how that would work. Imagine we've got producers and manufacturers. Say, a couple of slightly undernourished-looking chaps here—one is a producer, and the other is a manufacturer. Now, producers normally worry about prices falling. If you’re producing, mining, and producing a commodity, for example, wondering about what you'll eventually sell it for, you worry about falling prices. Whereas people manufacturing, using commodities such as, say, aluminum—which we’ll use in a moment—tend to be more worried about prices rising. They need to buy ahead. If you're Audi, for example, making cars out of the stuff, you need to be buying ahead for production in six months or a year's time, and your worry is: what happens if the price spikes in the meantime? Do I just chance it and wait six months to see what I end up paying, or should I do something about it?

So, here’s an example of how a simple forward contract will enable both parties to take away their respective concerns. A forward contract would simply be the producer saying to the manufacturer, "Well, look, I'll tell you what—why don't we just say that I agree to sell one ton of aluminum (I’ll just call it Al) when you need it in three months’ time, and we'll fix a price of, say, $25,000 per ton."

All right, so that's a bit spidery, but it says, "I agree to sell one ton of aluminum (Al) in three months at $25,000." The manufacturer thinks, "Great, that locks in my buying price." The producer is thinking, "Great, that locks in my selling price." Contract done. Two people involved—one as a buyer, one as a seller.

Basically, someone’s going to win, and someone’s going to lose in the sense that in three months' time, the market price of aluminum might be less than $25,000—who knows? At the London Metals Exchange, for example, if it’s less, then the buyer is going to wish they hadn’t signed this contract. If it’s more, then the seller's going to wish they hadn’t signed the contract. But that’s life! At least with this contract in place, both of them know how much the aluminum is going to be priced at when they come to deliver and receive it in three months' time.

So, at the end of three months, all that happens very simply is this: in order for the contract to be honored, as you’d expect, the producer sends one ton of aluminum (that’s a picture of a truck, by the way) to the manufacturer, and $25,000 goes the other way. And that’s a forward contract—useful to both parties. In this scenario, both parties are hedging their exposure to aluminum prices by locking in an agreed price three months ahead of when the aluminum is actually going to be ready for delivery.

Okay, so let’s take that a stage further. Let’s take that further on market price and say, "Right, go back to the beginning." So, we still have a producer and a manufacturer. Let’s say we still have contract number one, and let’s say that when this contract is signed, back at the start of the three-month period, the market price of aluminum is $22,000. So, the market price is the price they've agreed three months down the line. You might say that's slightly unrealistic in practice, but let's go with this example.

So, the contract is signed, and the manufacturer is thinking, "Great! I know I can buy aluminum in three months’ time at $25,000—that’s pretty similar to today’s market price." One month passes.

One month later

That's the start of the example. Now, let's say one month later (1 M later).

All right, the market price has changed. So, the market price of aluminum is now $30,000 a ton at the London Metals Exchange, or wherever you're getting the price from.

Okay, one month into this contract, we have a winner and a loser already. The manufacturer is thinking, "Brilliant! This contract means I can buy aluminum for $25,000, but the market price has already risen to $30,000, and we're only one month into this contract." Meanwhile, the seller is thinking, "Damn! I really wish I hadn't agreed to sell for $25,000 when the market price is $30,000. If I could sell now, I could make more money."

So, imagine this scenario: the producer puts a phone call into the manufacturer and says, "Um, I'd quite like out of that contract; it's got two months to run, and I'd quite like out of it now." The manufacturer might just say, "Tough. It's a contract—you are going to deliver one ton of aluminum to me in two months' time, and it's going to be at that price."

Or, the manufacturer might say, "You know what, I'm prepared to do a deal here." The producer is worried that if the price keeps rising, this contract only gets worse and worse for them, losing more and more money. The manufacturer, on the other hand, might be thinking, "This is just a price spike that's not going to last. I see the price dipping in the next couple of months quite sharply." So, actually, they’re happy to be out of this contract too—although they’re not going to say that out loud.

Let’s imagine that both sides want out of the contract early. What would need to happen? If this is a futures market, here's the answer: you can't rip up contracts because they're binding between these two parties. However, you can do something called novation, which is a technical term where you simply replace one contract with another.

So, let’s see how that would work and the end effect of it.

One month in, with two months left to run, what happens? The same two parties are involved, but now a second contract is drawn up. This time, the manufacturer says, "All right, here’s the deal I'm prepared to do with you. I agree (manufacturer talking now) to sell you one ton of aluminum in two months' time (since the original contract has only got two months left to run) at, well, let’s set the new market price, say, $30,000." So, the manufacturer says, "I'm prepared to set up a second contract to run alongside the first one."

The producer thinks about it and says, "All right." Now, this process of setting up a second contract that almost cancels the first one is called novation in the futures market. But who cares about the term? What's the effect of it?

Three months later, what’s going to happen?

All right, that’s from the start of the example. Now, we go to the end of the example. This is the beauty of what we’re going to call the futures market. Here's the painful way of sorting this out, and when you think about it, it’s not a sensible way to do it, but it’s possible.

You could take each contract separately. Contract number one requires the producer to sell a ton of aluminum to the manufacturer at a price of $25,000. Let’s leave that one to one side for a moment. So, the producer thinks, "Right, okay, I’ve either got to have a ton of aluminum on site ready to go, or I’ve got to go and find a ton of aluminum, so I can deliver it to the manufacturer and honor this contract. Otherwise, I get sued."

Let’s take the scenario where the producer thinks, "Oh, damn, I have a contract to fulfill. I better find a ton of aluminum." So, the producer goes into the open market. Let’s say the market price hasn’t changed in the last couple of months and is still $30,000. The producer finds a ton of aluminum at $30,000, then delivers it under this contract for $25,000, honoring contract number one.

Effectively, there’s now a ton of aluminum sitting over here, and the producer is already $5,000 down, having paid $30,000 to get the ton of aluminum and then only received $25,000 from delivering it. But now the second contract kicks in. The manufacturer turns the same ton of aluminum straight around and delivers it back to the producer for $30,000, honoring that contract.

The producer, not wanting a ton of aluminum, then sells it at the market price of $30,000. Now, this is one way of sorting out these two contracts. But frankly, why would you bother? Could you not just put them both in the bin to start with, all right, and have the producer pay $500 to the manufacturer? If neither party was actually interested in the physical delivery of aluminum, they could use these two contracts as a way of hedging price changes in aluminum. All that would happen is the producer, having locked in to sell at $25,000 and buy back at $30,000, has effectively lost $500 when these contracts expire, and the manufacturer has made $500.

Now, you might say, "Well, actually, these two parties might have an interest in selling and buying aluminum, so it's realistic." But I could change these into Trader One and Trader Two instead. They could set up the first contract with no intention of ever delivering aluminum, then set up the second contract when the price changes, still with no intention of delivering or receiving aluminum, and put both contracts in the bin. Trader One pays Trader Two $500, and the job is done. That would be called gambling on the price of aluminum, and that's the basis of futures markets contracts, which, in theory, can be bought and sold by anybody in the market. They don’t have to be manufacturers or producers. This process of novation I described allows anyone to theoretically gamble on the price of something like a commodity. In this case, $500 was won by Trader B and lost by Trader A.

Now, just to finish off this little video, let’s illustrate how that works. If that setup works for two people in the market, could it work for three? Here’s the beauty of futures markets: when you set up a contract, you don’t have to cancel it with the same person. If that sounds a bit strange, bear with me on this one.

I'm going to introduce three players into the market. Let’s see how that would work. With a bit of artistic license, instead of writing out all the details, I'll use L for Long and S for Short (selling), which will simplify things. Imagine you have three players in the market—A, B, and C—to show how futures markets could take these principles one step further.

Let’s set a market price for an asset traded on the open market, something simple like $10. It doesn’t really matter what the asset is; it could be a commodity, just for argument's sake.

Here's how it could work:

Day One: These are three traders in a futures market, none of whom want to take delivery of the asset. A thinks, "I want to bet on the price of this asset rising, so I’m going to set up a contract to buy it"—called a long position—at $10. It takes two people to make a contract, so B thinks the price of this commodity will fall and is happy to take the other side of that contract with A. In summary, A agrees to buy the asset in three months for $10, which I’ll summarize as Long $10. B has agreed to sell the asset in three months for $10, just like my aluminum example, but with shortened jargon.

Day Two: The market price for the asset is now $12. A is thinking, "Great, this is looking good. I've agreed to buy the asset for $10, and the market price is already $12, so if I demand the asset at $10, I’m already theoretically $2 up." B is thinking, "I've agreed to sell for $10 already, but the price is now $12. Damn." It’s like the aluminum producer in the last example.

A then decides, "This is a futures market—I’d like to take out my $2 profit now." So, A sells a contract at the new price of $12. B, however, might think, "I don’t want to close my position and realize a loss, so I’m not interested."

But here’s the advantage of a market. Trader C walks in and says, "Yeah, I’m prepared to take a gamble on the price of this asset. I think it’s going to keep rising, so I’ll buy the other side of A's contract for $12."

This leaves two players in the market. A has closed out by being both long and short in the same commodity, just at two different prices. A has effectively closed out any commitment to buy or sell the asset, leaving B betting on prices falling and C betting on prices rising.

Day Three: The price rises to $14 for the same asset. B and C decide to close out their positions, neither wanting to take or make delivery of the asset. How does that work? B, having sold a contract, would need to buy it back at the new price of $14, and C, having bought a contract originally, would need to sell it at the new price of $14.

This is just to illustrate how a futures market could work with three players.

What’s the overall result?

The asset in question has not been bought or sold by anyone—this is purely speculative.

All parties have closed out their open positions. You can't close out by being long twice or short twice; you need to be long and short—in other words, you need to buy and sell.

So, here’s the breakdown of the outcomes:

• A is sitting on a profit from buying at $10 and selling at $12, with a net profit of $2.
• B, having committed to sell this asset at $10 and needing to buy the contract back at $14, is down $4.
• C agreed to buy at $12 and exited by selling at the new price of $14, gaining a profit of $2.

So, here’s my point. Basically, everyone’s closed out their positions, and the math adds up: -4 + 2 + 2 equals zero. So, if you like, it all balances out. No aluminum, copper, gold, silver—whatever you like—has actually changed hands between any of these people. All they’ve done is used the futures market, organized by an exchange, to take a punt on prices. There have been two winners and one loser—a big loser, as it happens. And that’s how markets work. If it works for three people, it can work for 2,000, provided there’s always somebody in the market prepared to take the opposite view to yours. Normally, in markets, that’s the case.

So, to recap: Futures are based on forwards. Forwards are commonly used by producers and manufacturers in the real world to fix the price at which they take or make delivery of an asset. Those principles can be taken a step further and converted into tradable futures contracts. The advantage of futures contracts is that you don’t have to move any assets around, whatever those assets might be, in order to speculate on the price of them changing. That introduces the idea that as many people as you like can be involved in a futures market. It also introduces the idea that the volume and value of contracts traded on something like, say, copper, can far exceed the amount of copper that’s physically on the planet. Because, if this works for three people with no copper, aluminum, or gold moving around the market, then presumably, it could work for 10 million people doing the same thing.

And finally, a word of caution: Were you, as a professional trader, to leave a futures contract open by mistake, it has been known to happen. In the early days of futures trading in the American Midwest, one "muppet" at a bank left open a commitment to buy 20,000 head of cattle. The day arrived, and he hadn’t entered into the opposite contract that would have closed out his position, so he got a phone call from what’s called a clearinghouse saying, “Where would you like your 20,000 head of cattle?”

Now, clearly, you can’t drive them up Wall Street, if that makes sense—and by the way, you don’t just buy the head; you get the whole beast. So, that particular bank had to write a big check to find somewhere—a ranch and cattle hands—to put 20,000 head of cattle delivered under a futures contract they’d forgotten to close out.

In summary

On a futures market, just like the forwards example I gave you, you can, if you want, enter into contracts where you physically end up buying or selling a commodity. But it’s perfectly possible to use them for purely speculative purposes as well.