Futures: Who uses Futures?
Futures are used by four types of people
- producers, consumers, hedgers and speculators.
-
Producers
- The person or company actually producing the good sells futures
contracts to lock in a predetermined price. If a producer is
successful in selling futures contract to a consumer then they do
not need to worry about price fluctuations. If the producer believes
that the price of a commodity is very high, then they will sell the
contract to lock in.
For example, a farmer decides in April to produce 100,000 bushels of
corn for the summer. He believes that the price for corn is fairly
high and would be very happy if he got that price during harvest
time in September. Each corn futures contract is for 5,000 bushels,
so to lock in at this price the farmer sells 20 corn futures
contacts with a delivery date in August. If the spot
price for corn goes down throughout the summer then the futures
contact will be worth money. The farmer would close out his futures
position before delivery and realize a profit on the contract. When
the spot price is lower, the farmer would get less money for his
crops when he actually sells the physical commodity. The profit
realized on the futures contact would cover the lower price received
for the physical commodity.
- Commodity Users - This group buys futures contracts in order
to protect the price or to plan their business better. They use
futures for the same reason as producers, to lock in at a price. If
the current price of a commodity is favorable, the end user company
would buy a contract to reduce price risk and create more
predictability.
On the other side of the transaction might be a producer such as a
cereal manufacturer who needs to buy lots of corn. The manufacturer,
such as Kellogg, may be concerned that in the next three months the
price of corn will go up, and it will have to pay more than the
current price. To protect against this, Kellogg can buy futures
contracts at the current price. In three months Kellogg can fulfill
its obligation under the contracts by taking delivery of the corn.
This guarantees that regardless of how the price moves in the next
three months, Kellogg will pay no more than the current price for its
corn.
- Hedgers - Hedging is
protecting existing assets such as stock portfolio from a down turn in
prices by opening a futures contract. As a holder of the asset, you can
sell futures against your equity portfolio to avoid making a loss and
without having to incur the costs associated with selling your assets. To
"close" the futures position by buying the equivalent amount of futures in
the market. Losses in the underlying asset can therefore be compensated by
profit made on the futures position.
- Speculators - These are the risk takers. They buy or sell
futures contacts to try and make a profit by speculating on which
way the market will move. Unlike other kinds of
investments, such as stocks and bonds, when you trade futures, you do not
actually buy anything or own anything. You are speculating on the future
direction of the price in the commodity you are trading. This is like a
bet on future price direction. The terms "buy" and "sell" merely indicate
the direction you expect future prices will take. A speculator who
buys a futures contract, hopes to profit from rising prices. A speculator
who sells a futures contract, hopes to profit from declining prices.
If, for instance, you were speculating in corn, you would
buy a futures contract if you thought the price would be going up in the
future. You would sell a futures contract if you thought the price would
go down. For every trade, there is always a buyer and a seller. Neither
person has to own any corn to participate. You must only deposit
sufficient capital with a brokerage firm to insure that you will be able
to pay the losses if your trades lose money. Rather than taking
delivery or making delivery, you would merely offsets your position at
some time before the date set for future delivery. If price has moved in
the right direction, you will profit. If not, you will lose.
Speculators look at chart patters, fundamentals, demand, supply, and
other factors about an individual commodity and make a buy/sell
decision based on where they feel the price will be in several days,
weeks, or months. Even though speculators do not
actually deal in the physical commodities, they provide very important
intangible asset called "liquidity". This maintains an orderly market
where price changes from one trade to the next are small.
Next==>>
Strategies for Futures
The best way to avoid responsibility
is to say,
"I've got responsibilities."
--
Richard Bach (Excerpt from Illusions: The Adventures of a Reluctant Messiah)
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