You Can’t Tell The Future… But You Can Invest in Futures

Previously we talked about options, which are contracts based on securities that allow- but don’t require- investors to buy or sell shares at a certain price by a certain date. Futures are just like options, but without the “option”.

Investors who buy futures are required to purchases or sell assets at the agreed upon price on the agreed upon date. It’s a way for investors to speculate the direction of certain assets, such as commodities, precious metals, or treasury bonds.

How Did It Begin?

The history of futures trading dates all the way back to 1710- the Dojima Rice Exchange in Japan was created with the purpose of trading rice futures. The U.S. takes the distinction of creating the first official commodities exchange in the Western world- the Chicago Board of Trade, which formed in 1848, first started trading corn futures. Then followed wheat, soybeans, cotton, orange juice, and even cattle and pork. Another futures boom occurred in the 1970’s, when foreign currencies, precious metals, and T-Bonds were offered by various exchanges in the U.S.

Futures must be pretty popular to have stuck around for so long. But why do people like them so much?

Using Futures to Hedge Risk

Since futures can be traded for commodities, producers of said commodities use futures to hedge against potentially unfavorable price changes. Take wheat, for example. A wheat farmer might use futures to lock in a predetermined price for selling wheat, so if the market price dips below the futures price, the farmer actually makes a profit instead of losing money.

This is a valuable strategy for businesses that deal with volatile industries. The value of crops, oil, and precious metals can change dramatically based on uncontrollable circumstances(unsystematic risk), such as natural disasters, supply chain disruptions, or social trends.

Predicting the Future with (OJ) Futures

Orange juice futures are a good example of a commodity with lots of unsystematic risk- mainly weather. Oranges are mainly produced in Brazil in Florida, both of which are affected by hurricanes and intense freezes. Brazil also suffers from droughts.

Steep price increases in OJ could indicate a forthcoming natural disaster that endangers the orange supply, like a hurricane, earthquake or drought. Prices tend to increase around November in anticipation of a damaging winter.

On the other hand, OJ’s value could decrease based on public opinion. Take the U.S. for example- in recent years, we’ve seen a health conscious trend start to emerge. If consumers decided that orange juice didn’t fit into their new healthy lifestyle, there’d be less demand and prices would drop.

Dangers of Futures

We’ve seen many times in history, when huge panics led to devastating financial outcomes. That happened very recently with oil futures, when a massive selloff of contracts made the price of crude oil drop to about negative $37 per barrel. This occurred on April 20th, following supply chain disruptions caused by COVID-19, as well as news of the price war between Saudi Arabia and Russia- two major oil suppliers. With demand at an all-time low, and production remaining steady, oil producers were running out of storage space to put their oil.

Nearing the expiration date of WTI(West Texas Intermediate) futures, investors sold their contracts to dodge taking physical possession of the oil at the expiration date. As a result, the price dropped to a historic-negative-low.

Bottom Line

All in all, futures are pretty versatile. They can hedge against risk, or cause unprecedented market crashes. It’s worthwhile to understand how they work, so you can bet on your favorite commodities to earn some cash. With that said, futures are definitely not for everyone and you need to be VERY wealth and skilled to trade futures successfully.

That’s because, like options contracts, futures are highly leveraged so that a $0.01 price movement can impact your portfolio $10 or $100 per futures contract. Furthermore, futures contracts involve maximum liability to both the buyer and the seller. As the underlying stock price moves, either party to the agreement may have to deposit more money into their trading accounts to fulfill a daily obligation.

Unlike options, there is no strike price where either the Buyer or Seller has limited their downside; instead you really are along for the ride.