Introduction to futures

May 25th, 2008

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In our previous article, Who is to blame for surging food and oil prices?, we explained Michael Masters’ argument that the distortion of prices in the commodities futures market will affect the prices of commodities in the spot market (i.e. its real world market prices) and by extension, its inventory levels. If you can demolish that argument, you effectively demolish Michael Masters’ testimony.

We will not attempt to do that here. But today, we will introduce what futures is in order for you to have some understanding of the interaction between futures prices and spot prices.

First, what is a futures contract?

Basically, it is a contract to buy or sell something at a pre-determined price in the future. For example, if you buy a June futures contract for gold at $1000, it means you have entered a contract that obliges you to buy gold at $1000 in June. Conversely, if you sell a June futures contract for gold at $900, you are obliged to sell gold at $900 in June. In this example, gold is the “underlying” of the futures contract and June is the “expiry” of the futures contract. In the financial market, there are all sorts of “underlying” for futures, from stocks, bank bills, bonds, commodities and so on.

Thus, if you have an existing futures contract to obliges you to buy or sell an “underlying” in the future, you are said to have an open position. What if you want to absolve yourself from that future obligation? You need to enter an opposite futures position at the current market price to close out that position. For example, if you have already bought June futures for 100 ounce of gold, then you have to sell June futures for 100 ounce of gold at whatever the market price to close out your futures position. If you have already bought the futures at $950 per ounce and sold the futures (to close out your position) at $900 per ounce, then you have made a loss of $50 per ounce.

That’s all for the introduction to futures. For those who are un-initiated to futures, isn’t it surprisingly simple? Next, we will cover the basics of futures pricing.