Most investors are familiar with the mechanics of stock trading, monitoring their 401ks, and buying and selling mutual funds. However, when it comes to the topic of commodities and future's trading, we receive questions that are all over the board. Therefore, we have decided to prepare this month's newsletter as a brief tutorial on the future's market.
First, let us examine the definition of a futures contract. The following is an excerpt from the New York Mercantile Exchange. www.nymex.com:
Futures contracts are firm commitments to make or accept delivery of a specified quantity and quality of a commodity during a specific month in the future at a price agreed upon at the time the commitment is made. The buyer, known as the long, agrees to take delivery of the underlying commodity. The seller, known as the short, agrees to make delivery. Only a small number of contracts traded each year result in delivery of the underlying commodity. Instead, traders generally offset their futures positions before their contracts mature (a buyer will liquidate by selling the contract, the seller will liquidate by buying back the contract). The difference between the initial purchase or sale price and the price of the offsetting transaction represents the realized profit or loss.
Futures contracts trade in standardized units in a highly visible, extremely competitive, continuous open auction. In this way, futures lend themselves to widely diverse participation and efficient price discovery, giving an accurate picture of the market.
To do this effectively, the underlying market must meet three broad criteria: The prices of the underlying commodities must be volatile, there must be a diverse, large number of buyers and sellers, and the underlying physical products must be fungible, that is, products are interchangeable for purposes of shipment or storage. All market participants must work with a common denominator. Each understands that futures prices are quoted for products with precise specifications delivered to a specified point during a specified period of time.
Actually, deliveries of most futures contracts represent only a minuscule share of the trading volume; less than 1% in the case of energy. Precisely because the Exchange's physical commodity contracts allow actual delivery, they ensure that any market participant who desires will be able to transfer physical supply, and that the futures prices will be truly representative of cash market values.
Most market participants choose to buy or sell their physical supplies through existing channels, using futures or options to manage price risk and liquidating their positions before delivery.
What's available and where are commodities traded?
Now, let us look at some of the commodities that can be bought or sold in the futures market and where you find them. Among others, through the New York Mercantile Exchange (NYMEX) and/or The Chicago Board of Trade (CBOT) these commodities can be bought or sold.
Energy products (crude oil, natural gas, heating oil, gasoline, etc.)
For a commodity to be listed and fairly traded on an Exchange, it must meet certain general criteria:
There must be a liquid market for trading. You need many producers, end users and speculators interested in buying and selling the product.
The commodity must be able to be standardized. It must conform to precise delivery specifications.
There must be price transparency. Everyone sees the same price at the same time.
In the future's market, it is the Exchange's job to guarantee each trade. They ultimately act as the seller to every buyer and the buyer to every seller. On the NYMEX this is accomplished through a group of about 40 or 50 member firms called clearing members, who include some of the largest and best capitalized names in the banking and financial services industries.
Why buy or sell commodities?
Now that we know what types of commodities are traded, let's look at a few reasons why futures are traded and how they have become so important to our economy.
From a consumer's prospective we might think of the airline companies merging or filing bankruptcy due to rising jet fuel costs. It is imperative that they have a sound strategy for their fuel purchases and the future's markets provide them a way to manage that risk. The same holds true for trucking companies. If they are caught by rising diesel costs and are unable to pass through their fuel costs, they go out of business. If the rising fuel costs are passed through as fuel surcharges, those costs increase the price we pay for virtually all retail products.
Now let's look at the commodities market from the eyes of a producer. A farmer wanting to guarantee an acceptable price in the spring, for his fall-harvested crops, can do so if and when prices are favorable on the futures market. Likewise a ski resort may use weather derivatives to protect its revenue stream if the snowfall amount doesn't meet expectations and tourists stay away.
The Exchanges provide a wealth of educational material for those wanting to learn more than we can possibly share in our newsletter. The following link provides practical examples of how energy producers and energy consumers can buy and sell futures contracts to mitigate their risk exposure. The examples cover a wide spectrum of scenarios in which prices are rising, prices are falling, and for those taking physical delivery and those using future's as a financial hedge. Energy Hedging Examples
In closing, this newsletter is not intended to make you an expert on the futures markets. Our hope is that it unravels some of the mystique surrounding the markets that so impact our daily lives.