F is for Futures

We’ve already reached the letter F in the Elite Investor Club A to Z of Investing, and it’s another biggie. Fortunes have been made and lost in this type of investment – F is for Futures.

Let’s start with a definition. A futures contract requires the person buying it to buy or sell an asset such as a physical commodity or a financial instrument, at a specific price on a predetermined date in the future. Some futures contracts require you to take physical delivery of the asset, while others are settled in cash.

Why do we have futures? They began as a way of helping farmers to deal with the volatility in prices for their crops. By locking in a certain price ahead of time they could be sure of making a profit or at least limiting a loss. So if I agree to sell you my bushels of corn at ten pounds a bushel in six months time that price is locked in, even if the market price of a bushel of corn has rocketed to twenty pounds or slumped to three pounds. I know I’m going to get my ten pounds a bushel and can plan accordingly. You’ve heard the term hedging your bets? Well that’s exactly what the farmer is doing here.

All kinds of assets can be traded using futures contracts, including commodities, stocks, and bonds, grain, precious metals, electricity, oil, beef, orange juice, natural gas, foreign currencies, emissions credits and some financial instruments.

Futures started out as a way of helping producers hedge against price movements, but it wasn’t long before the traders and speculators moved in. Futures contracts can be bought and sold in a secondary market and are particularly attractive because you can use a very high degree of leverage compared to say the stock market. Because you can speculate on the price of a commodity going down as well as up, for a relatively small outlay you can win big if your hunch proves correct. And guess what, you can lose big if you’re wrong! You need to make sure you sell your position before the contract expires otherwise a big rotting pile of pork bellies will land on your driveway.

Jargon alert. Whether we’re talking futures contracts or share prices, if you think they’re going up you take a long position. If you think prices are heading down you’d take a short position. The more advanced strategy is to take a long and a short position at the same time. You have to place a deposit called a margin to make sure you have sufficient funds to cover any losses. If prices move against you the financial institution that you are trading through will ask you to make a further margin deposit.

Most investors can achieve the benefits and risks of futures contracts through spread betting, so the futures markets themselves are not an area for newbies to get involved in. What can be a useful advanced strategy is to see what price expectations are built into the futures markets, for example as a way of seeing likely movements in the oil price. You can then extrapolate that to predict share price movements in companies that serve the oil industry such as tankers, drilling rigs and support services.

Unless you’re a very experienced player, you’re best off leaving the futures markets to the professionals.