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Futures and Forward Contracts

Fortunes have been made and lost using futures. "A famous case was in 1974 when Mrs. Hillary Clinton, former first lady-turned U.S. senator, invested in cattle futures and turned $1,000 into approximately $98,000 in one year." These types of gains attract investors.  Because of their high leverage, futures are in the same investment category as options. Investors can control a large notional dollar amount of assets for a relatively small sum. The big difference is that with options, one’s loss is limited to the cost of the option, which is paid up front. With futures contracts, one is exposed for the entire notional amount of the contract. Understand the nuances; with options, one purchases the RIGHT to buy an asset; with futures one is actually PURCHASING the assets with a deferred closing date. Investors in futures contracts are responsible for the entire purchase price, not just the initial margin deposit.   

Futures and forwards are contracts to commit to the future delivery of a commodity at a specific price, quantity, quality, date, and delivery location. The goal is simple: for long positions, the holder is betting that the spot (market) price at the contract’s settlement date exceeds today’s future price, resulting in a gain. Long investors are betting that the price will increase. With short positions, one is selling a futures contract and agrees to deliver the commodity at a specified time and location. Short sellers are betting that the spot price at the delivery date will be less than today’s price; in effect, trying to sell high, and then buy low.

The profit potential with futures and forward contracts can be enormous! The risk, however, is unlimited; you can lose more than your margin deposit in your brokerage account. If a trade goes against you, you are still obligated to fulfill the contract until a reverse order is executed.  The brokerage firms allow you to buy on margin, with 5% to 10% normally the down payment requirement; that translates into approximately a 20 to 1 leverage ratio. A small change in price can wipe out the margin deposit, resulting in a margin call to adhere to the broker’s maintenance margin requirements. Losses can exceed your initial deposit.

Forwards versus Futures

Forward contracts are more informal, individually tailored, deferred delivery agreements between two parties. These agreements are not regulated by the Commodities Futures Trading Commission and are not executed through a clearinghouse. Payments are made on the settlement date. Like futures contracts, delivery of the commodity is normally not taken; it is more cost efficient to liquidate one’s position by reversing the trade before maturity than to take actual delivery. Very few contracts actually take physical delivery of the commodity; settling in cash is more cost beneficial.   

Futures contracts are standardized, deferred delivery contracts that trade on the exchanges and are regulated by the Commodities Futures Trading Commission, a federal agency. Standardized futures contracts became popular because they were flexible. If events disrupted the supply chain, adjustments could easily be made without renegotiating the original contract. Additionally, the clearinghouse made trading simple by guaranteeing that the other side of a transaction would be fulfilled. This provided security and liquidity to the market place, making it attractive to both hedgers and financial traders. Unlike forward contracts, futures contacts are “marked to market and settled daily, usually at the end of the day. Marking to market ensures that all participants fulfill their financial obligations.

Taxes

Because futures are marked-to-market daily and settled with cash, taxable income or loss is realized immediately, regardless of whether a position is closed out or not. It’s not like common stock, where you have some flexibility as to when sales take place, and can move gains or losses to a different tax year.

Hedgers and Speculators

Hedgers have a business purpose to trade futures contracts, while speculators have no business use for the commodity; they are merely trying to profit from price fluctuations. Financial traders are speculators.   

Examples:

Text book example: "Assume you are a wheat farmer and you want to lock in your profits as soon as your crop is planted. Selling a futures contract on the exchanges, for the quantity equivalent of your expected crop, hedges your position by fixing your selling price. The contract is with the commodity exchange, usually the Chicago Board of Trade (CBOT). The counter party would be the miller, who purchases the wheat for his processing, and is interested in locking in his cost structure. Both parties have a vested interest in hedging their positions. Normally, one closes out his position before the contract terminates and settles in cash; delivery is then handled through the normal channels."

Recent real world example: September 2005 –with oil prices at record levels and jet fuel selling at $92 a barrel, many airlines were struggling to survive; yet Southwest  Airlines was being recommended and on the buy list of many stock analysts. Southwest realized that their main cost was jet fuel, and purchased futures oil contracts for their expected usage, locking in their cost structure for a few years going out. They were hedged at $26 a barrel of crude, while the spot oil prices approached triple digits. Hedging correctly gave Southwest Airlines a major cost advantage over their competitors. Futures can result in life or death situations for businesses.

Fundamental and Technical Analysis

Similar to stock market investors, there are two types of investment styles:

·        Fundamental investors research supply and demand trends and base their trading decisions on them.

·        Technical investors base their trading decisions on price movements and chart patterns.

 

     
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