I’ve been trying to get an explanatio nof what a future is. I’ve been led to believe that if you buy a future, you’re not buying anything in particular. You only have the right to sell it later, but you’re not buying a pice or pound of anything, or a right to do anything. You’re just buying a “future” that is somehow pegged mostly to the price of some stock index or something.
So: what is a future? What are you really buying? How is a future pegged to the price of anything if they sort of don’t exist? Is it only convention that keeps the price similar to that of an index of “real” things?
Someone else will come along and give a better explaination, but it is not really true that no one ever receives the futures they buy. Futures were started to allow companies and individuals that deal in a certain commodity a way of protecting what an item like cotton or lumber is going to cost them in the future. Of course, the rest of us couldn’t stay out of it and so you or I would buy futures with no intent of taking delivery. I’m not sure if this works to the benefit or detriment of the original participants.
In a nutshell, an investor agree to pay a speculative price for a certain commodity (say, porkbellies) which will be available in the future. By paying upfront, the porkbelly supplier gets cash for his commodity before it is ready (in the future) and assures a profit for the season (very important in the agricultural biz). The buyer, OTOH, is hoping that he can get a good price today for something that will actually have a higher market value in the future, when he comes into possesion of it.
The commodity supplier’s ass is covered, because he makes a guaranteed profit (which he needs to work another day) and the investor has the opportunity to make a profit on his speculation.
I should have made it more clear that I’m not dealing here with commodities, but futures linked to stock indexes. I’m fairly sure that what’s been described here are essentially options. I could be wrong, but I discussed this pointedly with two knowledgable people for about 15 minutes.
Think of a futures transaction as a bet: you’re betting that the price of [fill in the blank] will be a certain amount on a certain date. The person selling the future is betting, for whatever reason, that it won’t.
A stock future is the same as a commodities future, except that it’s a bet on a stock index instead of a commoditity.
Just like the depressed guy, you also found the right guy on the right day. Luckily for both of you I’m a retired millionaire manic depressive 32 year old futures speculator. And thats no joke. Now your question. Here is the short answer. The S&P 500 contract is an agreement wherein the buyer agrees to pay the seller of the contract 100 times the value of the stock index on the third friday of the expiration month.
Now a longer answer
If the contract is trading at 1000 on the expiration date, then the buyer must deliver $100,000 to the bank of the seller (its actually a clearinghouse transaction but thats another story). What economic purpose does this serve? Hedging for fund managers who want to micromanage their risk from day to day without the costly and time consuming task of dumping actual cash stock. There are a number of other benefits like price discovery, but lets stick with the fundamental one for now. The S&P 500 is meant to be a general indicator of the value of the broad “stock market.” Of course, now there are many indexes to better indicate the pricing of different market sectors, in particular, the Nasdaq which deals with High tech companies, etc. Lets say our fund manager owns a whole bunch of stock, but is worried that next week Allen Greenspan will make comments about interest rate policy which will send the market down. He decides he doesnt want to take the risk and prefers to remain neutral, ie, have no position in the market. Now selling a whole mutual fund worth of stock is alot of paper work and very costly. Instead he finds a willing better, like a speculator to agree to bet on the price of the idex in the future. Now while the manager’s fund might not be a perfect mirror of the stocks in the S&P 500, it is a close enough proxy for his hedging purposes. There are stock index futures contracts that are timed to expire on the third friday of every March, June, Sept, and Dec of every year going out a number of years. If the fund manager owns $100,000 worth of stock, he needs to simply sell one contract( 1000 is the current futures price 100) to hedge his risk. So in an ideal world, if I owned $100,000 worth of stock and sold one contract that expired in sept, what ever I made/lost in my cash position, I would make up with a profit/loss in my futures position. It’s august right now and our manager is worried about just the short term so he sells a Sept future to a buyer at the current mkt price of 1000. He agrees to pay 100 the value of the index on the third friday of Sept at the close of the market. If the market goes down to 990 his cash position would have lost $1000 (again, thats a rough estimate cuz the stocks he owns is prbably not a perfect match of the stocks in S&P 500). But he made a contract with someone else who agreed on that day to buy that “basket” of stocks at 1000, not 990. So the fund manager makes 10*100=1000 on the futures contract and therefore has broken even. Only problem is, monkeys are better at picking where the stock market will go then fund managers. They are all hat and no cattle. They produce cocktail party conversation tripe about the market and dont actually know shite. That’s why speculators take the other side of there bets and wind up rich but insane.
Quote from KidCharlemagne:
“So in an ideal world, if I owned $100,000 worth of stock and sold one contract that expired in sept, what ever I made/lost in my cash position, I would make up with a profit/loss in my futures position.”
There was a great “Frontline” episode on PBS once that covered an attempt by some professors at Princeton(?)to create a market formula back in the 80’s. I think it won a pulitzer in economics. They’re belief was that the market would move in a predictable manner if all the variables were in place in the formula. Their investors were also taking a similiar approach to what is quoted above by KidCharlemagne. They made some big money (as did others who weren’t using their formula)and then…<poof>…they found out they couldn’t predict the unpredictable. The market can be very fickle.
I think upperdeckfan’s trying to describe the Black-Scholes theorem.
The Black-Scholes theorem is the basis for options pricing. Two of the economists associated with the theorem, Myron Scholes and Robert Merton, won the Nobel for economics in 1997. Prior to that, Merton and Scholes had started an investment firm, Long Term Capital Management. The firm eventually went bust. See:
Non-economists may be shocked (or amused) that a firm with such brainpower went under, but it isn’t much of a surprise to an economist. In a competitive market with smart traders sharing the same basic knowledge set (like, say, the Black-Scholes theorem,) all the easy profits will be rapidly competed away. What’s left is random, unpredictable movements in prices, pure risk that can make or break a speculator. To an economist, a well-functioning market ends up being a random one.
What is left after information is distributed equally is not randomn but chaotic, there is still an underlying pattern. In the end, black-scholes while useful for pricing options, is just another mean-reverting bet on a system that is inherently reflexive and will therefore martingale your ass out of the futures casino like it did the complete idiots at LTC. I know those guys - There were two types at that firm . Genius math geeks who created pricing models that attempted to model a non-linear dynamic system with linear math, or non-linear math that didnt adequately describe the system, and vaguely intuitive swingers who didnt know shite about risk management. The ideal trader is someone in between.
