What are futures? - MoneyWeek Investment Tutorials

so in this video we're going to take a look at the futures market basically the derivatives market as is called is made up of these things futures options and covered warrants which I do in another video and swaps which I've also done in another video once you've got the hang of those three groups of products you basically have all the planks required to understand derivatives so what our future's talked about in the context of commodities indices shares and bonds so let's start with the basic principles using a commodities based example and I'm going to use this example to illustrate all the key features bear with me if I use a little bit of artistic license in terms of the way the example works okay so let's set up an example of somebody who would use first of all something called a forward contract because the future is just an exchange-traded forward contract and forward contracts are very straightforward to understand most producers most manufacturers have their use for something in the forward market and the reason is they worry about price and this is a way basically to take out price risk okay so let's see how that would work so imagine I've got let's say a couple of sort of slightly undernourished kin Japs here one is a producer and the other is a manufacturer now producers how they worry about prices normally is that prices will fall if you're producing mining producing and commodity for example wondering about what you'll eventually sell it for you worry about falling prices whereas people can manufacture it using commodities such as the aluminium which we use in a moment tend to be more worried about prices rising they need to buy ahead if you're Aldi for example making cars out of the stuff you need to be buying ahead for production in six months or a year's time and your worry is what happens at the price spikes in the meantime do I just chance it wait six months and see what work when I'm not paying or should I do something about it so here's an example of how a simple forward contract will enable both parties to take away their respective concerns so a forward contract would simply be the producer saying to the manufacturer wallah I'll tell you what why don't we just say but I agree to sell excuse my spidery writing one tonne of aluminium I'll just call it al one tonne of aluminium when you need it in three months time and we'll fix a price of say two and a half thousand dollars per tonne alright so that's a bit spy driven it says I agreed to sell one tonne of aluminium al in three months at $1000 and the manufacturer thinks great that locks in my buying price the producers thinking great are locked in my selling price contracts done to people involved one is a buyer one is a seller okay and basically someone's going to win someone's going to lose in the sense that in three months time the market price of aluminium might be less than two and a thousand dollars who knows the london metals exchange for example if it's less then the buyers going to root wish they hadn't signed this contract if it's more than the seller is going to wish there and sign the contract but that's life at least with this contract in place both of them know how much the aluminium is going to be priced when they come here to deliver and take that of Ryoga in three months time so at the end of three months or what happens very simply is this in order for the contract be honored as you'd expect the producer sends a one ton of aluminium that is a picture of truck by the way one time of aluminium for manufacturer and two-and-a-half thousand dollars goes the other way and it sorry well as a forward contract and useful to both parties now in this scenario both parties are hedging their exposure to aluminium prices by locking in an agreed price three months ahead of when the aluminium - can be ready for delivery okay so let's take that a stage further let's take that further on and say right go back to the beginning so we've still got a producer a manufacturer on okay well we've still got contract number one and let's say that when this contract is signed back at the start of the three month period the market price of aluminium is two-and-a-half thousand dollars so the market price is the price they've agreed three months down the line now you might say that slightly unrealistic in practice let's go with it as an example so contract is signed manufacturer thinking great I know I can buy aluminium in three months time to another thousand dollars that's pretty similar to today's market price okay one month passes all right so that's the start of the example that's now let's say one month later one end later alright the market price has changed so the market price of aluminium is now three thousand dollars a tonne at the London Metal Exchange where we getting the price from okay all right in one month into this contract we have a winner and a loser already the manufacturer is thinking brilliant this contract means I can buy aluminum for two and a thousand dollars the market price is already risen to three I'm only one month in to this contract so far and the sellers thinking damn and really wish I hadn't agreed to sell for $2,000 when the market price is three if I could sell now I could make more money so imagine this scenario the producer puts a phone call in to the manufacturer and says I quite like out of that contract it's got two months to run I'd quite like out of it now the manufacturer might just say tough it's a contract you are going to deliver one ton of aluminium to me in two months time now and it's going to be that price okay or the manufacturer might say do you know what I'm prepared to do a deal here so the producers worried that if the price keeps on rising this contract gets worse and worse and worse it loses them more and more money the manufacturer might be thinking this is just a price spike okay bad is not going to last I see the price dipping in the next couple of months quite sharply so actually I'm happy to be out of this contract to clopsies I'm going to say that but that's what he's thinking so let's imagine that both sides want out of the contract early and what would need to happen this is a futures market and here's the answer you can't rip up contracts they're binding between these two parties but you can do something technical word coming up called no Veit them which is where you simply replace one contract with another so let's see how that would work and the end effect of it so one month in this is what happens same two parties involved but a second contract is drawn up and this time the manufacturer says all right here's the deal I'm prepared to do with you I agree manufacturer talking now to sell you one ton of aluminium in two months time because the original contract only got two months left to run okay well let's set the new market price so $3,000 right as the manufacturer says I'm prepared to set up a second contract I'm going to run alongside the first one and the producer thinks about it is alright now this process of setting up a second contract that almost cancels the first one is known in the futures market is Novation but who cares what's the effect of it okay we roll forward so three months later what's going to happen all right that's from the start at the example all right so we go to the end of the example well okay this is the beauty of what we're going to call the futures market in a moment here is the painful way of sorting this out okay and this when you think about it is not a sensible way to do it but you could you could take each contract separately so contract number one requires the producer to sell a ton of aluminium to the manufacturer at a price of two-and-a-half thousand dollars let's leave that one to one side so the producer thinks me right okay I've either got to have a ton of aluminium on site ready to go or worse I've got to go and find a ton of aluminium so that I can deliver it the manufacturer so let's take the second scenario where the producer thinks going down yeah I've got a contract right I better find a ton of aluminium so I can sell it and all of this contract otherwise I get sued so the producer goes into the open market and let's say the market price hasn't changed in the last couple of months and it's still three thousand dollars so the producer goes finds a ton of a living in three thousand dollars delivers it under this contract for two and a half thousand dollars okay and that honours contract number one so effectively is now a ton of aluminium sitting over here and the producer is already 500 dollars down having paid 3000 to get the ton of aluminium and then two and a half thousand only come in from delivering it but now the second contract kicks in so the manufacturer turns the same ton of aluminium straight round and delivers it back to the producer for $3,000 honouring that contract and the blue two things were one ton of a living room and sells it for $3,000 the market price okay now that is one way of sorting out these two contracts but frankly why would you bother could you're not just put them both in the bin to start with all right and have the producer pay $500 and the Macra all right if neither party was actually interested in physical delivery of aluminium they could use these two contracts as a way of hedging price changes in aluminium all right and all that would happen is the producer having locked in to sell it to an hour thousand and buy back at three has effectively lost $500 when these contracts expire and the manufacturers made $500 all right they might say well actually these two parties might have an interest in selling and buying aluminium is unrealistic but I could change these into trader one and trader two okay they could set up the first contract no intention of ever delivering aluminium then set up the second contract when the price changes still no intention of delivering or receiving aluminium but both contracts that have been trained a one-page trader to do $500 dropped up that would be called gambling on the price valu million and that's the basis of futures markets contracts which can be in theory bought and sold by anybody in the market don't have to be manufacturers and producers allow through this process of devotion are described basically any body in theory to gamble on the price of something like a commodity in this case $500 won by trader be lost by trader eh okay now just realist rate to finish off this little video just to illustrate if that works cause a bit of a mess if that works for two people in the market could it work for three and here's the beauty of futures markets is that when you set up a contract you don't have to cancel it with the same person if that sounds a bit weird bear with me on this one all right because what I'm going to do is just introduce three players into my market let's see how that would work now fit of artistic license here rather than having to write down by I'm just use L for long okay L for long and s for short or selling and that'll just simplify the amount of stuff I have to write on the screen but imagine you've got three players in the market a B and C just illustrate how a futures market could take those principles one step further all right let's write in a price for an asset traded on the open market of let's say so let's have a market price on day one of something nice and simple just ten dollars doesn't matter what the asset is could be a commodity for alchemist sake okay here's what happens these are now free traders in the futures market none of them want to take delivery of the asset ok so here's I could work a thinks on a bet on the price that's our set rising that's what I'm going to do is sell a contract to buy it called a long position at ten dollars now it takes two people to make a contract so B thinks the price of this commodity is going to fall and it's quite happy to take the other side of that contract with player a so this is what I mean by not writing out the full contracts again essentially L in summary says I agree to buy the asset in three months time for ten dollars I've summarized that as long ten dollars B has agreed to sell the asset in three months time for ten dollars so like my aluminum example just with shortened jargon okay now day two remember these are speculators now rather than producers and sellers they - the price in the open market for the asset is $12 hmm okay a is thinking great this is looking good I've basically agreed to buy gas at $10 and the market price is already 12 so if I pick up the phone and demand the asset for 10 I'm already in theory $2 up all right s and so B is thinking I've agreed to sell 10 already the price is 12 damn bit like my aluminium producer in the last example okay so mm-hmm let's see what happens next hey thinks do you know what I'd like this is a futures market I'd like to take out my $2 profit I Donna wait I'd like to take out my total profit now where that works is a sells a contract at the new price for $12 now you might be thinking I don't to play I don't want to close my position okay and realize a loss so I'm not interested in a bit like in the last example if the manufacturer on the side of the board just said one we're interested in to the second stage we're going to lead the first contract open but this is the advantage of a market in walks trader C and says yeah I'm prepared to take a gamble on the price of this asset I think actually it's going to keep rising so I will buy the other side of AIDS contract for a price of $12 hmm all right now this effectively leaves two players in the market hey has closed out by being long and short the same commodity just at two different prices a has effectively closed out any commitment to buy or sell the asset okay that leaves be betting on prices falling and see betting on prices Rises let's do one more day day three the price rises to $14 for the same asset I guess is the market price for the asset these people are gambling on at this point BNC this like to close out their positions and neither of them wanting to actually take or make delivery of the asset how'd that work be having sold a contract would need to buy it back at the new price of 40 and see and having bought a contract originally would need to sell it at the new price of $14 okay this is just to illustrate how a futures market could work in principle with three players in it what's the overall result first of all the asset in question has not been bought and sold by anybody this is all gambling okay all of them have closed out open positions you can't do that by being long twice or short twice you need to be long and short in other words you need to buy and sell okay so hey is sitting on a profit long ten short well buying something at ten closing a contract at twelve of $2 B unfortunately having committed to sell this asset at ten dollars and being forced to buy the contract back to avoid delivery of fourteen is down four dollars and C has agreed to buy up twelve got out of that commitment by selling a contract at the new price of fourteen so that's a profit of two dollars so here's my point I guess but basically everyone's closed out their positions minus 4 plus 2 plus 2 is 0 so the lads are picky like all right no aluminium copper gold silver what if you like has changed hands between any of these people all they've done is use the futures market organized by an exchange to take a punt on prices and there's been two winners from one loser one big loser as it happens and that's how markets work right if it works for three people it'll work for two thousand provided there is always and somebody in the market prepared to take the opposite view to you and normally a market that's the case all right so to recap futures are based on forwards forwards are commonly used by producers manufacturers in the real world to fix the price at which they take the Librium delivery of an asset okay those principles can be taken on a step further and converted into tradable futures contracts the advantage of futures contracts being you don't have to move any assets around whatever those assets might be in order to speculate on the price of them changing alright and that introduces the idea there as many people as you like can be evolved a futures market and that also introduces the idea that the volume and value of contracts traded on something like it's a copper mmm can far exceed the amount of copper that's physically on the planet because if this works for three people with no copper or aluminium or gold moving around the market then presumably it could work for 10 million people doing the same thing okay and finally a word of caution were you as a professional trader to leave a futures contract open by mistake has been known to happen in the early American Midwest the early days of futures trading there was one Muppet at a bank who left open a commitment to buy 20,000 head of cattle alright the day arrived he hadn't entered into the opposite contract that would have closed out the position so he got a phone call from what's called a Clearing House saying where would you like your twenty thousand head of cattle okay now clearly you can't drive for Marc Wall Street that makes sense and by the way you don't just buy the head you get the whole beast alright so that particular bank had to write a big check so that they could find somewhere a ranch in capital hand to put 20,000 head of cattle delivered under a futures contract they'd forgotten to close out alright so what I'm saying is all the futures market just like the forwards example I gave you you can if you want to enter into contracts where you physically end up buying or selling a commodity but it's perfectly possible to use them for purely speculative purposes as well

Channel: MoneyWeek

Views: 850,206

Rating: 4.9011559 out of 5

Keywords: Tutorial, Investment, Futures contract, money, trading, market, business, finance, learning, derivatives, Stock, Stocks

Id: nwR5b6E0Xo4

Length: 20min 30sec (1230 seconds)

Published: Fri Sep 30 2011