Futures-From Chicken Nuggets to S&P 500
Now that we understand stocks and bonds, let us understand some products that have emerged for them. One of that product is called as Futures. In this post, we explore the origins, uses, advantages and disadvantages and their implementation in our investment activities.
Futures is a derivative product. It does not have a value of its own and as the term derivatives suggests, it derives its value from an underlying asset which it represents. It will become clearer when we understand its origins.
Farmers have battled with nature since time immemorial as they strive to protect their crops and livestock from its mood swings. A particularly hot winter and a winter crop like orange will be destroyed. Too little rain and we have no rice. A bad case of bird flu and the entire chicken farm has to be culled.
Alternatively, weather has been so good that there is now a massive surplus of onions and there is not enough demand for it causing prices to fall so low that the crops sell for less than the costs it took to plant them. Farmers will make a loss if crops are destroyed and they will make a loss if the prices fall too much. A way out was desired and a need was felt for a product that would help protect the farmers. But for a product to sell, there has to be a buyer as well who would benefit equally if not more from that product. To understand that, let us look at the counterparties that will be affected due to the above mentioned events.
With the failure of orange crops, prices of oranges will shoot up. Companies that make orange juice like Coca Cola with Minute Maid or PepsiCo with Tropicana will have to bear the impact as they cannot just raise prices randomly. Similarly if rice fails and prices shoot up, Kellogg’s will suffer a loss in their Rice Krispies. A case of bird flu is bad news for McDonalds and their chicken nuggets. Companies whose manufactured products depend on agricultural commodities would like to fix their purchase price in order to protect their margins.
Now we have two parties who wish to fix a price for sale and purchase. This led to the creation of a type of contract where one would buy and one would sell at a current fixed price but on a later date. It is known as forward contract. E.g. A farmer producing corn will enter into a forward contract with Kellogg’s to sell a certain quantity a month from today but at a price fixed today. This benefits both farmers as well as Kellogg’s: The farmer gets a profitable price for its crop which might not be the case a month from now if the corn prices fall and Kellogg’s will get a firm price as well instead of risking a price rise in the future. Here we should understand an important activity called short selling or shorting before we move forward.
Short selling is the act of selling something you don’t own today in the hope of buying it back and delivering it in the future at a lower rate than what you sold. The difference between the selling amount and buying amount is the profit. This term originated when the American frontier was being explored. Hunters who would go hunting would promise certain number of bear skins and collect the money upfront and then deliver it at a future date. Sometimes they would miss the delivery quantity leading to a short delivery where short means less than asked.
In a forward contract, the farmer is selling something he doesn’t have right now. He/she believes that the price of their crop will decrease in the future and wants to lock in his price now before it falls. Similarly, the buyer, in this case Kellogg’s is buying the crop because it wants to keep its raw material costs fixed and doesn’t want to risk a price rise in the future. They enter a contract at a fixed price at a future delivery date. On the delivery date, the farmer has to supply the crop and the buyer has to pay for it and accept the delivery.
Like all good things in the world, this one too comes with its fair share of problems. The major risk in this type of contract is counterparty risk. Say a farmer entered a forward contract to sell 50 tons of corn to be delivered three months later at a price say $200/ton. Three months down, the farmer could only produce 40 tons and he now has to purchase remaining 10 tons from the market. But the market price is now $250/ton. So in effect the farmer will have to take on a loss of $2500 ($250*10 tons) to meet his/her contract obligations. Alternatively, the farmer could either deliver only 40 tons out of its contract or even more outrageously, not honor the contract at all and sell the entire 50 tons in the market at a higher price.
Similarly if the price of corn after three months was now $150/ton, the buyer could simply refuse to accept delivery choosing to buy from the market instead. At any point in time, the buyer or the seller could back out of the contract. This would lead to monetary loss as well as time, effort and costs involved in litigation. A middleman was needed to act as a common counterparty which led to the creation of clearing houses. We shall learn about them shortly.
Another issue with forward contracts is that they are not standardized. There can be numerous varieties of product and the contract would have to clearly specify the type, quality, grade etc. which makes the contract specific to the parties involved. Time duration was also variable and not fixed. Thus if one wanted to opt out of the contract, they could not simply sell it off and opt out but had to go through the tedious procedure of closing it out. This led to the birth of the futures contract.
A futures contract is a standardized, legal contract traded on the stock and commodity exchanges and guaranteed by a clearing house as the counterparty. It has all the features of a forward contract but improves upon certain shortcomings. All futures contract come with the same specifications, have the same end date also known as expiry date (since the contract expires on that date) and same quantities. For e.g. a futures contract of gold on COMEX (Chicago Mercantile Exchange) is of 100 troy ounces, is physically settled (i.e. physical delivery of gold. Some contracts are cash settled i.e. only differences in buying/selling and expiry prices are paid in cash), backed by a clearing house who will ensure delivery of gold or funds at the time of expiry, weekly and monthly contracts available (i.e. expiry every week and month).
This has made life simple for all the parties involved. Now, instead of spending days negotiating and finalizing contracts, going over the fine details and then facing counterparty risks, one simply has to go online, log into your account at the broker of your choice, select the contract, click on buy or sell and place the order. If you haven’t yet opened a brokerage account, then we recommend you open one at Interactive Brokers or TD Ameritrade, both are equally good, reliable and provide a vast range of analytical tools along with ease of execution and trading. An additional feature of futures contract and one which we shall discuss in detail in the later part of this post is that one is not required to pay the full money upfront at the time of placing the order. One only needs to pay a small amount, known as margin at the time of entering the contract and has to pay the full amount only on expiry when accepting the delivery.
So futures which began as a way of hedging commodity price risks by farmers and companies, saw an impressive application in stocks as well.
Application of futures contract in stocks
Futures contract started to be traded for various stocks and even entire indices like S&P 500. A futures contract for a stock consists of 100 quantities of that stock with a weekly or monthly expiry date. On the expiry date, the seller has to provide the stock and the buyer has to accept it. In case of indices, since there is no physical stock, it is cash settled, i.e. the difference between trade price and expiry price. For e.g. a futures contract on the S&P 500 traded at $100 closes no expiry at $105. In this case, the seller has to pay $500 ($5 per unit * 100) and the buyer receives that amount minus charges. Vice versa if it closes at $95.
The biggest advantage of futures trading is the leverage it provides by the virtue of only needing margin money. Let us take an example of Apple. Apple’s stock trades at $134 USD as of writing. To purchase 100 stocks of Apple, one would require to bring in $13,400 in cash. However if one were to purchase a future instead, it would require only $2,680. Now if Apple moves $6 to $140. In both cases, the profit is $600. However the person who purchased the stock made a return of 4% ($600/$13400) whereas the person who purchased future made a return of 22% ($600/$2680). However we would like to remind you guys, that trading with leverage is risky and losses with leverage can be devastating.
Use of futures in our investment portfolio
Futures are geared more towards producers, large companies and speculators (those that bet on price movements for money). It is not of much use to us as an investment tool. At the most, if one is falling short of money for purchasing the desired quantity, they can buy a future in order to lock in the price and buy it at a later date with the full money.
Other way to use it for your investments is various arbitrage methods that used to work before, do not work now due to large firms and efficient markets.
In the next post, we learn more about options and the wonderful way one can build their portfolio using options.