Investing 101: Futures

(It’s another Tuesday here at the Amateur Financier, and that means one thing: Yep, it’s another thrilling round of Investing 101.  Today, following our recent trend into considering more complex investments, we’re going to look at the futures market, and determine how these futures could help your financial future.)

Q: So what are futures, anyway?

A: When talking about futures, you’re really discussing futures contracts, agreements where you set the price for a commodity or financial products (stocks, bonds, Treasuries, or any number of other investments) at some point in the future.  Let’s say you’re an oil producer, and are afraid that continuing financial shakiness world-wide might lead to falling oil prices.  You can sell a futures contract locking in the current price of oil for the shipment you will produce for September delivery.  This way, you can be certain of the price that will get for your product when it becomes available.  The buyer of the contract also gets the certainty of knowing exactly much the oil will cost.

Q: Sounds pretty good; but why is there such a large market for futures?

A: Well, let’s take a closer look at some possibilities for what can happen between now (June) and September for our example.  If prices fall, as you (the oil producer) expect, then you win; having sold the contract, you locked in your profits, and ensured you will get the desired amount of profit for your oil.  The holder of your contract, on the other hand, loses; he or she has an obligation to purchase your oil at the higher price.  If the holder tries to sell the contract, he or she would have to sell for less than the face value of the contract, to make it attractive to the purchaser.

But, that doesn’t have to be the case.  If oil prices rises, then you, as the contract writer, would have to deliver the oil at lower prices than the current market value.  In this case, the contract holder would win, and could profit in one of two ways: first, he or she could take delivery of your oil at less than market value, pocketing the difference between the amount he or she actually paid and the current cost of that oil.  Or, second, the contract could sell on the futures exchanges for more than the initial cost.

Because of the possibility that the contracts become more valuable, an extensive secondary market in futures has arisen, allowing you to buy or sell contracts, even if you have no intention of taking delivery of the underlying product.  Most people investing in future contracts, especially for raw materials, do so with the intention of making a profit by reselling the contract later, rather than getting the underlying product.

Q: So, why would I want to invest in future contracts?

A: There are several reasons to consider investing in futures.  First, if by chance you are a manufacturer or user of various industrial or agricultural raw materials, it can make sense to lock in your prices to guarantee your future profits or expenses.  This way, you can ensure your future profits and more easily plan out your financial future.

Or you could use futures as a means of speculation, similar to options.  In this way, you can benefit from the increased leverage offered by futures, allowing you to make bigger profits than by holding the underlying assets.  It’s another way to take advantage of leverage, if you so desire.

Q: Sounds good!  Any last comments?

A: As with any form of speculation, you need to be extraordinarily careful about how much you invest in the futures market.  Make sure you know exactly what you are doing before you invest any real money, and only make futures contracts a small part of your portfolio.  Unless you have need for a particular commodity for your business and are using the futures contracts to lock in the future costs, chances are that you don’t REALLY need to invest in futures, and should treat your future contracts very carefully.

That’s all for this week; hopefully, you’ve appreciated this introduction to futures contracts, and have an easier time understanding what futures investing is all about.

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