The more you learn about financial markets, the more you notice that there is a place in which money changes hands in the same way that boxes of fish do in a market early in the morning. I’m no expert, I just work designing a tool for trading, so I have commited myself to explaining these three ideas in less than five minutes so I can be sure that I have learned everything right.

Instruments

Imagine you own cows. Not a cow… cows; they give milk; a lot. You put that milk in 25 litre jars and take it to the market, looking for people willing to pay for it. Since the seven jars you are carrying are not practical to move around the market looking for a buyer, at the entrance of the square somebody has set an office in which you leave all those jars. In exchange you get a piece of paper for each of those jars saying the owner of this piece of paper owns 25 litres of milk. Now you can get into the market with just seven pieces of paper which you will sell to whoever ofers a price that you consider fair. You keep the money and he keeps the paper to change it for the milk or for whatever he considers. It could be the baker buying it in order to cover a new order, or it could be bought by someone who you don’t know what he does for living but that accepts the price with the hope of finding someone in a couple of hours willing to pay a better price for it. He does not care about the milk. He buys that piece of paper at a low price, sells it at a higher one and gets the diference. Milk, eggs (because in the market you can get eggs too), meat or Toyota equities are called instruments, and they are happily sold and bought in stock exchanges all accross the globe. And when I’m talking about the milk market you might be thinking about a square in a town in the past century, but nowadays you can go to a stock exchange to trade on corn, soy or almost anything you can think of.

Futures

Let’s say that you also have a smarty brother in low who warns you that next fall this market is going to be open to farmers from three more valleys. That would mean more milk in the market, so you could fear that the price of what you produce goes down. Because of that you go to the market and on top of turning the seven jars of milk you are carrying into paper, you ask for seven extra pieces of paper that also are worth a jar of milk each but that this trade won’t be effective until September 1st. You sell these pieces of paper in the same way as previously, with the only diference that these pieces of paper can’t be traded for milk until the date set on them. You might notice that both you and your buyer are betting. You fear the price going down and would rather take the money now. However, if the day comes and milk is being sold at double the price there is nothing you can do to get a better deal. Your buyer, on the other hand, is expecting the oposite. He does not need the milk now but fears that the price might go up. And, the same as happened in the previous section, there are some buyers in the market who could not care less about milk, they are just playing not only to see what happens with the milk in a month, but what happens with that piece of paper they are buying now within a matter of hours. And again, you can say milk or Twitter equities. Anyone else is thinking of a casino? This papers in which you give me the money today and I’ll give you the milk in the future are called futures.

Options

To make things worst, one day you are in the market and one of this guys fearing the milk to be more expensive within a month comes to you. He says: “Look, on September 1st I need three jars of milk, and I can’t pay more than 300€ for them. If you agree I can pay now 20€ for the option (but not the obligation) of buying that day at that price”. Those 20€ are yours, you won’t lose them. If September comes, even if you could go to the market and sell those 3 jars for 370€ you’ll have to accept 300€ you agreed on with your buyer. However, if that milk is worth 280€ your buyer wont execute that piece of paper, will consider those 20€ lost and will go to the market to buy a cheaper milk, which lets you with all the milk and the 20€ you got before. He is not forced, he just has the option of executing that contract and that’s the reason for the name.

Paper and more paper

If you have made it until here and have understood everything, I hope you see that this is not so difficult to understand as some people wants to make us believe (anyways, I would not be able to make a dime with all this). And now picture two things in your mind. First, the guy owning the cows and the one buying milk don’t mind in these markets, since they are dominated by those people that try to buy the piece of paper with the only hope of selling it at a better price. They come and go every day just with some money hoping that every day that pile of money is slightly bigger than the day before. And second, think that the paper is so XX century that now everything are entries in a database and numbers flashing in a computer screen. That way you’ll probably understand why there is people working with me who insted of having experience designing or coding software for trading, they come from the field of online gambling.

Lovely right?