Explain commodities futures trading to me like I'm a retard

Factual Questions
1

I’ve been trying to read the Wikipedia articles but they devolve into unexplained jargon so quickly that I can’t make head or tail of them.

Specific questions I have. From here:

This seems to imply there’s only ever one sale per contract. Can you resell a contract? If so, what happens to the margin that you’ve filed with the exchange? Don’t contracts change hands many times over before the strike date?

Daily? Huh? Why?

OK now I’m completely lost. How can that happen? Why are contracts cancelled out? Wasn’t the contract with someone producing a commodity? What happened to the actual production if the contract is cancelled?

From here:

:confused:

WTF?

I guess what neither of those articles explain is precisely how the whole thing works. Say I want to buy a barrel of light sweet crude that will be produced next April. What do I actually do? Pick up the phone and say “buy” - do I set a price at which I will buy? What if I want to sell it to someone else? If I can, in the last month or week before the contract matures, does the price stabilise closer to the current market price? Who do I sell the contract to if I don’t actually want to take delivery of the oil? Etc.

Completely bamboozled. Please help.

2

You see, Billy, when a pork belly and a bushel of corn wuv eachother very much . . .

Or try this.

3

Yes Koxinga, prior to my attempting to research the subject that scene was pretty much my entire understanding of how it works.

4

My understanding is it works like this. Let’s say you and I form a contract that I will buy one thousand tons of avocados from you on January 1 for $250,000. And then you and Koxinga form a contract that he will sell you one thousand tons of avocados on January 1 for $200,000. (Or vice versa, you could have made the agreement with Koxinga before your agreement with me.)

The point is that you’ve balanced out the purchase and the sale. So you no longer care what the price of avocados does. Koxinga and I may make a profit or take a loss depending on where prices go between now and January 1. But you’re guaranteed to make $50,000.

5

OK, but surely there’s still some kind of a contract - between you and Koxinga. Or two contracts between all three of us. What’s been cancelled?

6

I’m not going to try and explain it (others can do that much better than me!) but I would point you at an old ('60s) detective story, Emma Lathen’s Sweet and Low, which is based around manipulation of the cocoa market. Does a really good job of explaining commodities trading so that even I could understand it :dubious:

7

I think this should satisfy the criterion set by the OP.

8

If I can piggy back a related question. Say you agree to buy xx oranges at harvest at $yyy. There is a frost and a smaller orange harvest, oranges are worth more, you make a big profit.

Except - where do you get your oranges if they where all damaged by the frost?

9

The reason why we do these trades on exchanges is precisely to avoid the whole “you owe me three and I owe you two” situation. The exchange keeps track of all the transactions, so when it’s time to settle you only need to pay (or receive) the net amount.

Yes, you can resell them (and people frequently do; the majority of commodity futures are traded by people who don’t intend to take delivery.) These contracts are basically fungible, like currency, so don’t think of it as selling a specific piece of paper. You’re just selling a certain amount of it. I don’t quite understand your question about margin – if you resell a contract, then you either have enough to pay off any credit or you don’t (if the value went down.) So you’ll need to come up with some extra cash or lose the collateral.

That’s just the way they do it. Back in the day you had a short trading day of a few hours and then the exchange people would go into a back room and settle all the accounts. Now it’s faster with everything computerized.

No, the contract was with someone selling a contract. :slight_smile: People selling contracts don’t generally own the underlying commodity (if they did, they’d have to keep it around in a warehouse until the contract date, which is a waste of money and not a good idea if you’re selling bananas.) If you hold the selling end of a futures contract on the closing date, then you have to purchase and deliver that amount of the underlying commodity to whoever holds the buying end. If your instincts about the “spot market” (that is, the market for buying the commodity right now, not the futures market) were correct, then hopefully you sold the futures contract for more than it cost to buy the actual commodity and deliver it. If you were wrong, then you lost money, but your counterparty got his commodity for less than he would have to pay for it today.

Dudes yelling at each other in trading pits, as opposed to electronic trading. It’s a dying art.

Well, you need an account with someone who can trade on the exchange; most investment banks can set you up. Then you tell them what futures to buy. The price is set by supply and demand on the market, just like stocks. If a lot of people want April sweet crude, the price of that contract will go up. If a lot of people want to get rid of it, the price will go down. You can resell your contract at any time up to the delivery date. If you actually want to take delivery, you don’t sell the contract to anyone, you keep it.

10

So… trying to absorb everything upthread, I can enter into the futures market just by offering Y, which I don’t own, to be delivered on X date. So if I still own this contract, when it comes close to date X, I have to find someone who actually produces Y, buy it at market price and have it delivered to the person I’ve got the contract with? But what I’d hope to do is divest myself of that contract altogether before X?

I still don’t get the cancelling out thing though.

And the daily margin settlement is just adjusting who has the upper hand fiscally at the end of the day? It doesn’t mean you have to be out of the market at the end of the day does it?

11

Not necessarily. If you think you can sell a futures contract today for more money than Y will cost a month from now, then you can hold the contract and make a profit when it comes time to deliver. (Of course you will lose money if you’re wrong.)

12

Yes, this is basically correct. In your example you would be “short” a contract. At contract expiration shorts are responsible for making delivery of the underlying, while longs must take delivery.

Futures markets are a zero-sum game for the participants. For every speculator that buys a futures contract, there is a seller. For every speculator that makes a million dollars, another loses a million. As contracts approach expiration speculators unwind their positions so as to avoid having to make/take delivery. When the speculators close out their front month contracts (selling longs/buying in shorts) the open interest (number of contracts trading) drops. When the dust settles, the only people left with contracts are physical end-users who will then make/take delivery.

Correct.

13

Basically cancelling is this -

I contract to deliver 30,000 pounds of bananas on Oct 31st for $30,000. You hold the other end of that contract.

October 31st rolls around and those bananas are worth $50,000. What do you want, $50,000 or 15 tons of bananas. Usually, paying out the contract at current market price is the simplest solution all around. Then you can contact fruits-r-us and have the necessary bananas delivered where you want them. Considering the extra costs of handling and storing commodities, unles you are a banana warehouse, cash is preferable.

If I get a “buy” contract to match the “sell” then for me, bananas = 0.

Futures are for 2 purposes. Farmers, for example, want a guaranteed price up front for what they will produce - helps pay for seed, fertilizer etc. BUyers - restaurants, grocery stores, want to know they will have a steady supply of pork bellies at a reliable price. The exchange connects the two.

Like every other trade, then everyone else gets in on the act and start making extra contracts. Anyone can promise to sell you something if you want to buy. Of course, if they promise to deliver bananas and don’t have the goods, they better have the cash to make good on their promise whatever the current market price. Not sure what he guarantees required by the Exchange are against default, but there’s some sort of backing to ensure you don’t just walk away and tell the other side, “sorry, no bananas and no money”.

Then there’s options, just for fun. I will pay you for the right to buy or to not buy a contract to deliver at $X, say 30,000lb of bananas for Oct 31st for $50,000. I will decide by Oct 25th. If I choose not to (price of bananas has gone up, delivering those bananas will cost more than $50,000) then the option expires. If by Oct 25 it looks like I can buy bananas on the 31st for $30,000 then I exercise the option, get a contract that you will buy them for $50,000, presto- $20,000 profit unless there’s a deep freeze in Central American before Halloween.

This is much like a real estate option - I will pay you $1,000 for the right to buy your house in the next 6 months for $500,000. If I choose not to, you keep the $1,000 and house, but I haven’t taken on a $500,000 mortgage if I decide by then the house is not worth it.

Since the price of commodities can fluctuate wildly, it is the quickest way to lose your shirt. However, options either expire worthless or you can get a healthy payout.

14

Futures were originally quite simple. A buyer and seller would agree on a price for something that would be sold in the future. This is still the basics of all futures. I’m going to use an example to try and explain.

Lets say you’ve got two companies, an oil company and a trucking company. The oil company has an oil deposit and they are trying to decide whether to invest the money to start a well. If oil is above $70 per barrel the well will make money, if it’s below $70 they will lose money. The well will take 1 year to build and in the past few years oil has varied between $40 & $100. Should they build the well? The trucking company has the opportunity to take on a new contract that will run for multiple years. They can stockpile 1 years worth oil but any more will spoil. If the price of oil is below $80 a barrel they will make money, if it is below $80 they will lose money (pretend trucks run on oil, not gasoline). Should they take the contract? So both companies have to make decisions now without knowing what prices in the future will be.

So the two companies come together and agree on a price of $75 per barrel in 1 years time. This will allow both companies to know they are going to make a profit. This kind of contract has been around for thousands of years. Companies try to eliminate the uncertainty by agreeing to a price.

In reality finding two companies that have matching needs would be very difficult. This is where an exchange comes in. The exchange will make standard contracts. For example a standard contract for oil is 1,000 barrels of West Texas Intermediate oil delivered to Cushing Oklahoma on the 25th of the month. The exchange will issue two contracts, one to buy the oil (long) and one to sell oil (short).

The oil company buys a short contract and the trucking company buys a long contract at $75 per barrel, due in 1 year. After 1 year the price of oil is now $85 per barrel. The oil company delivers 1,000 barrels of oil to Cushing on the 25th and receives $75,000 and the trucking company picks up 1,000 barrels of oil at Cushing on the 25th and receives $85,000.

Now imagine the oil company is in California and the trucking company is in New York. Neither one wants to own oil located in Cushing Oklahoma. So the oil company sells the oil at the current price ($85 per barrel) to a company in California and receives $85,000. The trucking company buys oil from a company in New York for $75,000. The oil company then sends the trucking company $10,000 and both companies have the same amount of money as if they had completed the contract.

There are two ways the above could happen on an exchange. Firstly the oil company could buy the long contract from the trucking company a few days before it expires. Since the oil company would then own both the long and short contracts, they would cancel out. Alternatively many contracts can only be settled financially and there will never be any goods exchanged. In this case once the future expires the exchange would make the oil company pay the trucking company.

Now this is pretty simplified but it gives an idea of how futures can work. As you can see above they are designed to allow producers and users to determine future prices. A few more things to note:

There will often be a mismatch between what is needed and the standard contract. For example the trucking company really wants gasoline not oil. The price of gasoline is made up of the cost of oil, which is widely variable, and the cost of refining, which is more stable. If the cost of refining is say between $5-6, then the cost of gasoline will vary between $45 and $106 per barrel. If the trucking company knows they have locked in the price of oil at $75, then their price of gasoline will only vary between $80 and $81. This mismatch is a major reason that most contracts are settled by transferring money rather than goods.

Margins: As you can see in the example above the oil company ends up owing the trucking company $10,000. The exchange will make you put money into an account with the exchange to cover the amount you are likely to owe when the contract expires. This amount will vary based on the current price of the commodity.

Things get a lot more complex in the real world but hopefully by using a simplified example it will be easier to understand the basic workings. I realize this is pretty long, and many of my points have probably been made by other posters as I’ve typed.

15

This is what clearing houses are for. The CME Group, owner of the major futures exchange in the US (Chicago Mercantile Exchange, Chicago Board of Trade, New York Mercantile Exchange) actually operates its own clearing house. See here for a description of how CME clearing works.

16

A related anecdote, one of my clients was a commodities trader. The office was filled with Macadmia nuts. There was a bowl of them on every desk and table, and trash cans full of them in the storage closets. They had received a call one day from somebody asking what to do with the train car full of Macadamia nuts they owned. Unlike purely financial instruments, there’s a real product involved, and sometimes there’s something left over. They never touched the actual commodity, just traded paper, and had no idea what to do with them, so they kept them.

17

One question that you forgot to ask but I’m sure is on your mind is “what is the whole point of the futures market!”? To answer that question, pretend you’re Minute Maid. Well before the orange season begins you have contracts with grocery stores to deliver a certain amount of juice on certain dates and at certain prices - and you have contracts with farmers and other producers to deliver oranges to your factories on certain dates and at certain prices. Let’s say a hurricane hits Florida and wipes out the crops for several of the farmers you have contracts with so they can not deliver. Now Minute Maid is forced to make up the lost oranges by buying at high market prices, and since they already agreed on a price for the reseller they would end up taking a huge (potentially company destorying) loss. These sorts of fluctuations happen every single year to one commodity or another and would make it nearly impossible to maintain a long running and successful business. The solution is to pass the risk to a futures market - this is called Hedging. So when Minute Maid buys oranges at a low futures price and the price suddenly skyrockets based on bad weather the result is: Minute Maid loses money because they have to buy oranges at a higher price, but they make a killing on the futures market because they bought low and sold high. The loss offsets. Conversely, if Minute Maid buys a future contract at a high price, but there’s a record crop causing the price to plummet then Minute Maid will lose money on the futures but make it up on cheaper oranges. The end result is - the futures market is like prosac to people who actually work with the real commodity - it evens out the highs and the lows so they can function normally.

18

At the bank I used to work for, I heard a story that an unexpected large delivery of gold bullion was dropped off at the office building where the bank’s back office was located. They had to scurry and rustle up some security guys to take it to the bank’s gold vault across town. (No freebies for the recipients, sadly.)

19

This isn’t quite right. There’s no such thing as a “short contract” and “long contract.” There is only one contract - 1000 barrels of oil to be delivered at Cushing, OK on X date. One party is short the contract (has agreed to sell at $75/bbl), and one party is long the contract (has agreed to buy at $75/bbl). At the time of delivery the buyer pays the seller $75,000 for 1000 bbls of oil. The current spot price of $85 is irrelevant. (Technically, this example is more like a forward contract than an exchange traded futures contract).

20

As I understand it (and this is really dumbing it down), if you’re trading futures you don’t care about the actual bananas.

All you care about is that you have a piece of paper naming a price $X for something that will be worth $Y on date Z. On date Z, the paper will be worth plus or minus (Y - X), depending on which side of the trade you’re on.

Before date Z, you can close out your position by buying the opposite contract (a sell if you held a buy, and vice versa). If your original purchase was a good one, and prices have moved in your favour, this will leave you with no banana obligation but some cash left over. If the market has moved against you, however, you will have to pay the difference in order to get out of supplying any bananas.