Many say futures markets is good. Others say they are bad. I fall into the thought camp of the former.
Futures markets work. We would be worse off without them.
Here are 7 reasons why.
1. Transparency
One reason futures markets are great is for the opposite reason other markets could be better. Futures markets are completely transparent while other markets (the peanut market, for example) seem to be shrouded in mystery. I have heard many farmers complain about what buyers were offering for peanuts in a given season, trying to figure out which buyer had the best price, and then wondering where companies are coming up with their prices in the first place. Go open a futures/options account with a reputable Introducing Broker though, you can see – in real time – every bid /offer on every single contract offered! What could be more transparent than that?
2. Basis for Forward Contracts
A futures market also allows itself to be something than we can all easily point to. Want to know where that price came from? Well with futures markets in the background, forward contracts also transform from an enigma into a derivative. For instance: “We are contracting at 400 off Dec. cotton, 31-3-36 or better, no remarks.” Prices are public and known, a basis is factored in, quality is accounted for, and the mystery is taken out of prices offered in forward contracts.
3. Hedging Option
Futures contracts also offer us another alternative to hedge. Instead of only forward contracting, or selling our crop for cash – futures contracts (along with options) offer us two more ways in which to lock in prices. Hedging options are doubled in number. Aren’t more choices better than fewer choices?
4. Ability to Offset
Unlike the hedging ability of forward contracts, futures and options require no physical delivery of your crop. This can be a huge benefit. Say you forward sell 1,000 bales of cotton – and between poor rain and bad hail – you only produce 500 bales of cotton. You better hope the price of cotton has not recently run up, where you are buying 80 cent cotton at market, to fill a $.70 forward contract. That, or hope your contract has a multi-year delivery clause in it. With an option, you can hedge your crop at $.70, watch the market run up to $.90 and walk away from your option contract. You just count the option premium as an expense, and sell your crop at market for $.90.
5. Options
As I have already said, futures do not stand alone. Futures also come with the compliment of options. In addition to options giving us another hedging alternative – options allow us to hedge without the dreaded prospect of a “margin call.”
6. Speculation
Futures and options further, allow us to speculate. This is also a good thing, because it allows more liquidity in the market – with more buyers and sellers both willing to trade at a mutually agreed on prices. Risk-seekers (or speculators) many times take the opposite side of the risk-adverse (or hedger). One can trade cotton without actually having physical cotton in the field or in a warehouse. Try doing that with pecans.
7. Social Gain
Finally, the biggest benefit of a thriving futures market is the social gain that results. Futures markets are what some call a “zero-sum game.” This just means that what I gain – you lose, or what I lose – you gain. If I buy a cotton futures contract from you at $.80, you are short cotton at $.80, while I am long cotton at $.80. For every penny cotton goes up, I will gain $500, and you will loose $500. The opposite will happen if prices go down. If both the buyer and the seller of a particular futures contract are speculators, they are both voluntarily entering a calculated risk. In the end, one will have a cash loss and one will have a cash gain – but both took a risk that they were both willing to take. And that is a social benefit.
But what if the buyer of a particular futures (or options) contract is a speculator, while the seller of the same contract is a hedger? For example: A cotton producer sells cotton at $.70 and a speculator takes the opposite position. Harvest comes and cotton is $.80. The speculator has a $.10 profit, and the cotton producer sells his cotton for $.70 ($.80 cash cotton – $.10 hedging loss).
In this example, some would say the speculator had a $.10 gain and the cotton producer had a $.10 loss – end of story. While that is true, it is, however, not compete. The speculator took a calculated risk and came out on top. Which was what he wanted. The cotton grower hedged his crop at $.70 and offset all (or most) of his risk. Which was what he wanted. They both got what they wanted out of the transaction – and that makes both of them better off.
This is also true if the roles were reversed. What if the speculator was the one that sold at $.70, and the hedger (maybe a textile mill) was the one that bought. With the same move to $.80, the speculator would have a $.10 loss and the textile mill would have a $.10 gain. The speculator was again able to enter a trade with the proper risk/reward (although this time he lost money), and the hedger was again able to offset price risk by locking in $.70.
Once again, both parties to the trade got what they wanted – and that makes both of them better off.
In fact, it makes us all better off.