Futures and Options Q & A | Trade Futures

PREFACE: Although much time, effort and energy has gone into this brief overview of the commodities industry, please consult our brokers at to help explain any questions you may have. We are a full-service commodity brokerage firm, and we pride ourselves in helping to explain the many nuances of the marketplace.

Furthermore, please remember, when dealing with commodities, there are two ways to become active in the market: with futures; and with options. Whichever you choose, we hope the information provided on the following pages will shed some useful light on the subject.

1.What is the Purpose of the Futures markets?

The futures markets permit farmers, producers and owners of commodities (e.g., wheat, heating oil, sugar, gold, stocks, and bonds) to transfer the risk of growing and owning these commodities to futures speculators. Those who use the futures markets to transfer risk, such as farmers, are called hedgers. Speculators are those who assume the risk of a price change that hedgers seek to avoid. Speculators seek the opportunity to profit. When a speculator assumes price risk, this allows the hedger to concentrate on the more controllable aspects of his business, such as growing corn. Futures speculation is unlike most investments in that price movements are magnified by leverage, as a result of deposit requirements representing only 5-10% percent of the full contract value. Additional margin deposits may be required, depending on market fluctuations. Price changes adversely affecting the hedgers’ physical position, such as the farmer’s cornfield, can be offset by a comparable price change in the futures position.

The futures exchanges, no matter how they are organized and operate, exist because they provide two vital economic functions for the market place: risk transfer and price discovery, or for simplification, price information. The futures markets make it possible for those who want to manage price risk – called hedgers, and also for those individuals who are willing to accept the transferal of some or all of that risk – called speculators.

2. What is Hedging?

A primary economic function of the futures markets is hedging. Hedging is the buying and selling of futures contracts to offset the risks of changing prices in the cash markets, or where the commodities actually get bought and sold. This risk-transfer mechanism has made futures contracts virtually indispensable to companies, farmers and financial institutions around the world for over a century.

Hedgers are individuals or companies that own a cash commodity, or are planning to own a cash commodity (corn, soybeans, wheat, U.S. Treasury bonds, notes, bills, etc.). Therefore, these companies are concerned that the cost of the commodity may change before they either buy it or sell it. To alleviate some of that concern, they seek price protection by hedging the commodity. Almost anyone who seeks protection against unwanted price changes in the cash market can use the futures markets for hedging (i.e.) farmers, merchandisers, producers, exporters, bankers, bond dealers, insurance companies, money managers, pension fund managers, portfolio managers, thrifts, manufacturers, and others. Farmers hedge the price of their crops against the price going down. Heating oil distributors hedge the value of their heating oil inventory.

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3. What is Speculation?

Speculators in the futures markets fulfill several vital economic functions by facilitating the marketing of basic commodities and the trading in financial instruments. Speculators do not create risk; they assume it in the hope of making a profit. In a market without these risk takers, it would be difficult, if not impossible, for hedgers to agree on a price because the sellers (or short hedgers) want the highest price, while the buyers (or long hedgers) want the lowest possible price. In addition to assuming risk, providing liquidity and capital, speculators help ensure the stability of the market. Speculators trade in the futures markets to profit from price fluctuations. The price of grain, for example, changes along with supply and demand. Plentiful supplies at harvest time usually means a lower price for grain. Higher prices may result from such things as adverse weather conditions during the growing season or an unexpected increase in export demand. Financial instruments fluctuate in price due to changes in interest rates and various economic and political factors.

When speculating in the futures markets, both profits and losses are possible – just as in owning the actual, physical commodity.

Speculators “buy contracts” (go long) when expecting prices to increase, hoping to later make an offsetting sale at a higher price, thus, at a profit. Speculators “sell contracts” (go short) when expecting prices to fall, hoping to later make an offsetting purchase at a lower price, again, at a profit. What is unique about futures is that a speculator can enter the market by either purchasing or selling a futures contract. The speculator’s decision of whether he should buy or sell depends on his/hers market expectations.

The profit potential is proportional to the amount of risk that is assumed and the speculator’s skill in forecasting price movement. Potential gains and losses are as great for the selling (going short) speculator as for the buying (going long) speculator. Whether long or short, speculators can offset their positions and never have to make, or take, delivery of the actual commodity.

4. Should I Invest in Futures?

Trading futures contracts is clearly not for everyone. Since the leverage inherent in futures contracts can work against an investor as well as for them, losses can mount quickly if the market moves adversely. Many investors do not feel qualified to assume that sort of highly leveraged risk. Others are too heavily occupied with their own professions to devote proper time and attention to active futures trading. For both of these groups, options will prove especially attractive. An option is exercised only when it is in one’s interest to do so. For example, the buyer of an option to purchase a house for $90,000 would be foolish to exercise their option if the market value of the house fell to $60,000. On the other hand, it would be to their advantage to exercise the right to acquire the house for $90,000 if the house increased in value to $120,000.

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