What are futures? - MoneyWeek Investment Tutorials

Summary

This video provides an in-depth explanation of Futures contracts within the derivatives market, using a commodities example to illustrate how these contracts work. It covers the basic principles of forward contracts and how they can be used to hedge price risks. The video explores how producers and manufacturers use Futures to lock in prices and manage market fluctuations. Additionally, it explains how these contracts can be traded, even speculatively, and the process of 'novation' that allows contracts to be replaced without physical delivery of assets. The video concludes with a cautionary tale about the risks of leaving Futures contracts open.

Takeaways

• 😀 Futures markets are a segment of the derivatives market, encompassing instruments like futures, options, covered warrants, and swaps, which allow individuals and companies to hedge against price risks.
• 😀 A **forward contract** is a private agreement between two parties (e.g., a producer and a manufacturer) to buy or sell an asset at a fixed price at a future date, providing protection against price fluctuations.
• 😀 Futures are essentially **exchange-traded forward contracts**, but standardized and tradable by anyone, unlike private forward contracts which are typically used by producers and manufacturers.
• 😀 Producers are generally concerned about falling prices, while manufacturers worry about rising prices—**forward contracts** allow both to lock in prices and manage their respective risks.
• 😀 The key concept in a forward contract is price **certainty**—both parties agree to a fixed price at the start, removing the uncertainty of future price movements.
• 😀 **Novation** in futures markets allows one contract to be replaced with another, making it possible to exit or modify agreements before the contract’s original expiration date.
• 😀 Futures contracts allow speculators to bet on price movements without taking physical delivery of the asset. These contracts are used to **hedge** risks or **speculate** on market fluctuations.
• 😀 In futures trading, **speculators** can make profits or losses based on price changes of an underlying asset, like aluminum, without ever owning the physical commodity.
• 😀 Futures markets can involve multiple traders, and contracts can be **closed out** at any time by offsetting trades, with traders betting on rising or falling prices without taking delivery of the asset.
• 😀 While futures markets allow speculation, there are significant **risks** involved—especially when contracts are left open, as a historical example illustrates, where a bank was forced to take delivery of 20,000 head of cattle because they failed to close their position.

Q & A

What is the difference between a Futures contract and a forward contract?

A Futures contract is an exchange-traded contract with standardized terms, while a forward contract is a private agreement between two parties. Futures allow for easy transfer and liquidity, whereas forwards are more tailored to specific needs and are not traded on exchanges.

Why do producers and manufacturers use Futures contracts?

Producers use Futures contracts to hedge against the risk of falling prices for their commodities, while manufacturers use them to lock in the price of raw materials to avoid price increases in the future.

How does a simple forward contract work in the example of aluminum?

In the example, a producer agrees to sell one ton of aluminum at $25,000 in three months to a manufacturer. This locks in a price for both parties, providing certainty about future costs and revenues. However, if the market price changes, one party may benefit while the other loses.

What is the concept of novation in the Futures market?

Novation refers to replacing one Futures contract with another. This allows parties to exit a contract early by transferring their obligations to a third party, effectively 'canceling' the original contract without breaking the terms.

How do Futures contracts help speculators?

Speculators use Futures contracts to bet on the future price movements of commodities. They can buy contracts when they expect prices to rise and sell them when they anticipate a price drop, without ever taking physical delivery of the commodity.

What happens when a Futures contract is not closed out in time?

If a Futures contract is not closed out before the expiration date, the trader may be required to physically deliver the commodity (or take delivery). An example in the transcript shows how a trader forgot to close out a contract for 20,000 head of cattle, resulting in a costly mistake.

Can Futures contracts be traded without physical delivery of the underlying asset?

Yes, Futures contracts can be bought and sold without any physical delivery of the commodity. The contracts are often used purely for speculation, where traders profit from price movements rather than from owning the commodity itself.

What role does liquidity play in Futures markets?

Liquidity in Futures markets allows for the easy buying and selling of contracts. As many traders participate in these markets, positions can be quickly entered or exited, making it easier for speculators to bet on price changes and for producers and manufacturers to hedge risks.

How does the Futures market work with multiple traders?

In a Futures market, multiple traders can enter into contracts with opposing views on price movement. For example, one trader may go long (buy), while another goes short (sell). Contracts can be bought and sold among many participants, creating a dynamic market without physical delivery of the asset.

What can happen if a trader forgets to close out a position in a Futures contract?

If a trader forgets to close out a position, they may face unexpected delivery obligations. For example, a trader who forgot to offset their contract could be forced to take delivery of a commodity, like the infamous case of a trader who was stuck with 20,000 head of cattle.