How to understand
the Futures Market
(Part 1)

Never let the future disturb you. You will meet it, if you have to, with the same weapons of reason which today arm you against the present.
Marcus Aurelius

What are we talking about?

The future interests me – I’m going to spend the rest of my life there.
Mark Twain

Forwards and futures are two types of financial derivatives, because their value is based on the price of another asset, which is called the underlying asset. For example, the value of a wheat future is based on the price of wheat. Although forwards and futures news sometimes appears in the press, most people don’t seem to know much about them.

Trading in the futures or forward market is not as simple as doing it in the spot market, which is the immediate delivery market, where you pay for something and get it. Forwards and futures reflect contracts that involve future delivery.

One feature is that there is not a single price in the forwards and futures markets, but a different price for each different future delivery date. In general, there are forwards and futures markets for products that can be stored, but it is not an exact rule.

Origins: Rice

The future ain’t what it used to be.
Yogui Berra

Forwards precede futures. Futures contract correspond to a more sophisticated idea. They have their origin in the agricultural market, specifically in the grain market.

Both derivatives originated around 1670 at the Dojima Rice Exchange, located in Osaka, Japan. Initially, rice farmers went to Dojima and made a deal to sell their grain to a warehouse, then they waited for the harvest and took the rice to Dojima and see what price they could get. They also had the option of setting the price earlier and lock it.

Dojima market was very important for all Japan. Producers and warehouses went to trade rice or rice products. Because the volume was so large, they started making contracts for future delivery. They had something that we could call rice bills, since the rice worked like money. You could borrow rice and return it in the future.

Operations in Dojima market became more sophisticated. In addition, it was transformed into a rice information and coverage center. Thus, they began to keep lists with the delivery dates of the rice. But they went even further, as they generated a series of specifications for the futures contract: they had warehouse experts, types of rice, date and place of delivery, and future prices.

In this way, the future contract was standardized, which allowed transactions with it and which also created liquidity in the rice market.

After World War II, Dojima market was lost and rice futures began trading on the Chicago Board of Trade (CBOT), United States. In 2007, CBOT merged with the Chicago Mercantile Exchange (CME). Standard contracts are traded there, for quantities of 2,000 hundredweights of rice.

Forwards

The only thing we know about the future is that it will be different.
Peter Drucker

As we mentioned, forwards preceded futures. Forward is a contract between two parties, to deliver something at a future date called exercise date or expiration date. As forwards contract are agreed between two counterparties, there are not a standardized contract.

We have already indicated that producers like to lock the price. Imagine a grain producer, who goes directly to a warehouse to a grain elevator and indicates that he plans to harvest rice in a specific month. Then he asks you: will you buy it and will you give me a price today?

Due to the complexity of the agricultural market, most do not have hedging in the futures market. However, the warehouse is almost always protected, because it will store. Hedging, or risk coverage, is the storage business. It is very competitive and narrow margin. In this way, the warehouses become hedgers and will quote prices to producers as forward prices.

Forward‘s counterparties are trapped in the contract, with no possibility of leaving it. So, imagine the following: you have signed a forward contract for wheat and the farmer (your counterparty) had a bad year and cannot harvest. What about you? You have been bad luck. In a forward contract, you have to trust your counterparty and expect him to fulfill the contract. In a future, this situation does not happen.

Futures

I never think of the future – it comes soon enough.
Albert Einstein

A future contract is like a forward contract, but with an intermediary. The difference is that you make the contract with the intermediary and not with the definitive counterparty. It is not a contract between the grain producer and the warehouse. The farmer negotiates with an intermediary, and so does the warehouse. Another important difference is that futures are standardized contracts.

To trade in the futures market, simply call your broker, who will enter into a contract with a third party. When buying a future, you do not need to pay the present value or the future value at the time of purchase, but rather a margin account is opened, which is a fund for the broker to operate.

In futures contracts in important what is called margin calls. When an investor uses the margin to buy securities, they are paid to use a combination of their own funds and money borrowed from a broker. The investor receives a margin call from a broker if the portfolio’s values ​​decrease in value beyond one point. After this, the investor must deposit more money in the account or liquidate assets. You don’t want to get that call, which basically tells you that you’ve lost your money. It is a factor that makes this market very stressful.

In the future market, you should not worry about your counterparty, but about your broker. When you invest in futures, you are facing a living element, which changes every day with the variations in the margin. Why do you buy futures? Because you are concerned about prices going up and you want to lock it. In this logic, if the price falls, it moves against you and your broker will remove that amount from your margin account.

Go to the articles:

How to understand the futures market (part 2)

What happened to the price of the oil in April 2020?

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