In a futures contract two parties agree to exchange an asset (gold, currencies, stock indexes, hog bellies) for a price agreed upon today (the strike price) but with delivery to take place at a specified future date. The party agreeing to buy the underlying asset, is said to be "long" and hopes the price will go up, and the party agreeing to sell the asset is said to be "short" believing that the price will decline.
Eric, Jill and John decided on going for a weekend trip outside the city. They are packing their stuff into John’s car. Jill is going through a list of things they should take with them, while the guys are checking if every item is in place.
To minimize the risk of default both parties must put up an initial amount of cash, known as “margin,” usually about 5-15% of the value of the contract. Investors get the benefit of leverage since they only put up a small fraction of the value of the contract. Large businesses use futures as a way of hedging risk. In our opinion futures are a valuable tool for speculation in precious metals, but should not be used for long-term investments.
If something rallies, futures rally many times more but the price for this leverage is that you can lose more than you invest.
A futures contract is a derivative instrument used for speculation or hedging. From a precious metals investor’s point of view, the speculative function of futures is of primary importance. One is able to leverage his or her position using futures, because when purchasing futures one is required to pay only a small part of the value of the contract (a completely new futures contract in your balance sheet for 10% of its worth only!!!). This part is called the deposit, or another name for it is “margin.”
For instance, let’s say an investor who has $1 000 is able to buy a futures contract worth $10 000. He pays the deposit of $1 000 but risk the whole value of the contract if it doesn’t go his way. If the market moves by 10% in the direction anticipated by the buyer, he will gain 10% * $10 000 = $1 000 instead of 10% * $1 000 = $100. The leverage has enabled a tenfold increase in profit. However, if the market moves by 10% the other way, the investor will lose $1 000 instead of $100. So one may lose more money ($1 000) than they have actually invested ($100) Futures enables the opening of bigger positions but they also increase the risk.
In the latter situation, when one is at a loss, the broker will make what is known as a margin call (Hello, good day Sir, you've just lost all of your money on this position, how about putting some more on the table?). This means that the investor will have to pay an additional amount of money to increase the value of the deposit. He can either do that, or sell the futures contract. In order to maintain the position, one needs to possess the amount of money required to complete the deposit.
One can manage the risk involved thanks to a stop-loss order. The investor gives the broker the instruction to sell futures if the price falls below a specified level (below the stop price). This means that the precious metals investor does not need to track the price all the time (Did I close that position in futures? Can’t quite recall…) – if the price of gold or silver hits the stop price, the position will be closed automatically by the broker. In a highly volatile market a stop-loss order can help one avoid significant losses (I’ve lost only 10%... The market is BOUND to move up… Oh, it hasn’t…).
The volatility of the precious metals market is also the reason why one usually does not use futures to maintain long-term positions. If the price of gold or silver changes rapidly, the aforementioned required deposit may increase its value as well and it may account for a bigger part of the value of the whole futures contract, then it was initially. (Sir, your position is $1 000 000 and your deposit amounts to approximately $10… Yes, it is a margin call). The bigger the deposit, the smaller the leverage, because one needs more money to cover the position. As the volatility of the prices of metals is higher in long-time spans than in short ones, it is more likely that the deposit will rise significantly in the long-term. Moreover, in extreme situations (like serious shortage of precious metals) the value of the deposit may exceed the value of the whole contract. In such a situation one needs more money than the contract is worth to maintain the position. (It is easy to imagine that it would be more profitable to simply buy physical gold/silver).
Another risk is that, in case of serious shortage of gold/silver, or in case of serious financial crises, futures trading can be limited by the regulating authorities. This may mean that one will not be able to open/close their positions in futures as they desire, and trapped in the position, they may see their profits evaporate or their losses soar.
What is a futures contract?
Having highlighted the practical applications of futures, it is essential to understand what a futures contract really is. A futures contract is an agreement between two parties to do a deal, for instance to exchange currencies, to exchange stocks for money etc. The asset in question is called “the underlying asset”). This exchange is obligatory. You cannot pull out of the deal in any other way than selling the futures contract – but will there be anyone willing to buy? that’s another question. The difference between a regular deal and a futures contract is that in the futures contract the parties agree on the price at which the currencies, stocks, commodities etc.(the underlying asset) will be delivered at some specified future time. Market prices are subject to change in the time span between the agreement and the delivery. Therefore, futures give the opportunity to speculate or to hedge. For instance, if you believe that the price of gold will rocket, you can buy a futures contract to buy gold – the other side (who apparently does not believe that the price of gold will rise. They believe it will either stay the same or decline) agree to buy gold in the future for a price close to the current price (You believe that gold’s price will SURELY go above the offered price and if you buy futures for that price, you will make a bundle.) Please keep in mind that there are no SURE things in the market. Things are not BOUND to happen, they are just likely to happen, or not.).
If the futures contract goes your way and gold actually performs well and goes up, then you pay the agreed upon price on the delivery date that was specified in the contract and in exchange you receive gold, which is worth more today than its price when you made the futures contract. This is speculation. You can speculate if you believe the price of gold will go up, and also if you believe the price will go down. In the former you are going “long”, and in the latter you are going “short.” If you believe that gold will correct sharply, you can buy a futures contract to sell gold. The other side to the deal agrees to sell gold in the future for a price close to the current price. If the price of gold does fall, than you get the gold on the delivery date for the agreed price, which is higher than the actual price at the time of the delivery date (because during the duration of the contract the price went down, which is what you believed will happen, which is why you made the deal in the first place.) The other party cannot deny you the right to get the gold at the agreed upon price, even though they are losing money. The trade is obligatory for both parties.
Why does one use futures instead of simply buying/selling metals, stocks etc.?
In the abovementioned examples it seems that it might be easier to simply buy gold if you believe the price is going up or sell it in the case that you expect it to go down.. Why buy/sell a futures contracts? This is pretty simple. When you buy a futures contract to buy gold, you ill not actually receive physical gold on the delivery date. Neither will the other party pay the full amount of money. In reality, the two parties settle by paying/receiving the difference between the initial price and the price on the delivery date (OK, Mr Smith, you would’ve gained $1 000 on this deal – we will simply pay you this amount).
For instance, the buyer acquires a futures contract to buy gold, the amount of the contract is $10 000 and the agreed upon price of the gold is $1000. (The reason the buyer did this deal is because he belives the price will be higher than $1000 and he will be able to make a profit.) Let’s assume that he was right, the price on the delivery date turns out to be $1050. In that case, the buyer receives $10 000 * ($1 100 / $1 000) = $1 000. On the other hand, if the trade didn’t go as anticipated and the price goes down and turns out to be $900, than the buyer needs to pay $10 000 * (1 - $900 / $1 000) = $1 000, or a $1000 loss.
What is important here is that the buyer is not expected to pay the full amount of money ($10 000) on the agreement. He needs to pay only a small part of the value of the contract as a security deposit (as has been said before). This allows the buyer to speculate with the amount of money ($10 000) he do not actually possess. This is the speculative advantage of futures.
Futures are also used by businesses as a way to hedge their risk. Business entities sometimes possess assets they are not able to dispose of immediately. For example, let’s say a company exports semiconductors from the USA to Germany receives its payments in euros. If the euro is relatively strong compared to the dollar, then the company is able to exchange its revenue for more dollars than if the the euro were weak. If the euro loses strength, however, it means that the company will receive fewer dollars for one euro and, therefore, will receive fewer dollars in exchange for its revenue. This means that its profit will be smaller. The firm is not able to change its target market each and every time the euro loses strength.
If the revenue of the company is €1 000 000 and the EUR/USD exchange rate is 1.5, then the company will receive €1 000 000 * 1.5 = $1 500 000. However, if the EUR/USD exchange rate falls to 1.4, the firm will receive €1 000 000 * 1.4 = $1 400 000. This means the company would lose $100 000 only because of exchange rate fluctuations. As you know, currency exchange rates change rapidly – this is why foreign exchange is so risky).
Now, if the company had hedged its risk by buying a EUR/USD futures contract, the underlying EUR/USD exchange rate 1.5, and the value of the contract €1 000 000, it would have received €1 000 000 * (1.5 - 1.4) = $100 000 from the futures contract. This amount would have compensated it for the aforementioned loss of profit. Futures can be used a hedging tool and sometimes it is easier to buy a futures contract that to sell one’s assets. Sometimes you might use futures to secure you profit.
Futures and long-term investments
We don't view futures nor forwards as a good way to invest one's long-term capital. There are three main reasons for that:
- Leverage and deposit requirements. The risk of being thrown out of the market because price declined very sharply and you need to increase your deposit (for which you don't have cash at that moment) is quite high.
- Risk of changing rules for the futures market. Regulatory agencies can impose virtually any requirement for holders of long futures contracts. For instance you could suddenly face an increase in the required deposit levels that exceeds the actual value of the metal that would likely force you to get out of the market - things like that have already happened.
- Counterparty risk. This type of risk is minimized on the futures market because of the marking-to-market mechanism, however it still exists. In case of a financial meltdown of sorts we would likely see much higher gold and silver prices. However, if the futures exchange that you're currently dealing with collapsed as well, then you might have trouble realizing your profits from your precious metals investments.