This video is sponsored by Skillshare go to SKS h / the plain bagel 3 to get a free 2 month premium trial on investment news channels there are often ribbons. With scrolling text or tables to the side showing future prices you might see that gold features are trading. At $1500 or that oil features are trading at 55 these prices don’t equal what the commodity is currently trading at.
So what are they some magic numbers showing what these commodities will trade for at a later date well. Yeah kind of you see these numbers are related to the aptly named future derivative in. Investment security that involves buying and selling of an asset typically a standardized. Commodity in the future these investments were originally intended for producers looking to manage business costs but have since evolved into a. Fundamental component of the investment industry they have many uses and while they are complex in nature they can fundamentally alter the traits of your portfolio if used.
Properly so today let’s go over futures the related forward contract and why people use them on today’s clean bagel imagine you are a baker who makes bagels if you. Sell these bagels for six dollars a dozen and will say that the only ingredient is flour which costs you four dollars.
A batch great bagels I know your gross profit for every dozen bagels ends up being two dollars not bad for your. Small operation but the cost of flour plays an important role in maintaining this margin and if it were to increase to say six dollars you’d be in a bit of. A pickle so being the proactive business owner you are you decide to reach out to a flower producer and enter a supply agreement where in a year’s time you’ll buy. Flour from them at a loft in price this ensures that you’ll be able to buy flour for the same price further down the. Road and while you’ll simultaneously trade away any upside you’d experience if prices of flour dropped it will.
At least allow you to spend less time worrying about the market and more time making bagels this is essentially how a future. Works a future is a derivative agreement that involves the sale of something at a future date with. A predetermined price known as the forward price which is determined today the person who goes along on. The contract is a person who agrees to buy the item in. Question and pays the forward price in this case our Baker and the person who shorts the contract agrees to sell at the forward price in.
This case the flour producer when someone enters a future contract they are obligated to carry out the transaction for the underlying asset in the future at the delivery date no matter. How profitable or unprofitable it ends up being well these contracts originated as a way for companies to hedge their costs such as. In our example these days future contracts are widely used by speculators looking to gain exposure to anything from oil to orange juice precious metals to livestock. They can even be used to gain exposure to financial assets like individual stocks Treasury bonds popular indices like the S&P 500 and now even. Bitcoin so how do these futures offer speculators exposure to the price appreciation of an asset well let’s go through an. Example imagine that you want to invest in gold you believe a recession is coming and that investors will flock to the metal as.
A safe haven something that will increase the price of the precious metal the spot price or current. Market price for an ounce of gold is $1,500 however you don’t want to physically. Buy and sell commodities so you instead turn to the futures market where we can get a hundred ounces of the stuff in a year’s time at a forward price of one thousand. Five hundred and fifty dollars an ounce now the higher future price takes into account a number of factors such as inflation risk-free rates of return and the costs and income. Received for holding the asset but to simplify things future prices will typically be lower.
For assets that are beneficial to hold like dividend paying stocks and higher for assets. They’re costly to hold such as cattle what you have to feed after all for something that’s. Costly to hold buying the asset in the future means you avoid those costs and leave them to the person going short on the. Contract so the price will compensate them for this there’s actually a formula.
For determining what a future contract Ford price should be but that could take up a whole video itself so we’ll just tick with the basics here but going back to our example. For the gold contract you decide to take a long position agreeing to buy 100 ounces for a total of 155 thousand dollars the price per ounce. Times 100 ounces the money you make on the investment your return will depend on the spot price of the asset when the contract expires in one. Year the price increases above one thousand five hundred and. Fifty dollars say to have seventeen hundred then you’ll earn a profit of 15 thousand since you’ll buy the gold for 155 thousand dollars and sell it at the. Spot market for one hundred and seventy thousand if it instead falls to 14 hundred then you’ll lose 15 thousand since you’ll have to buy the gold at a future price that’s higher.
Than the current spot price but what if instead of expecting gold prices to rise you actually expect them to. Fall with an impending recession you may assume the government and central bank will stimulate the economy encouraging investors to leave. Gold and invest in the stock market there by depressing gold prices well by going short and agreeing to sell. The gold in a year’s time you invert the return if the price falls below 15 hundred and fifty dollars you would be able to buy gold at the lower spot price.
And sell at the higher forward price to profit now you may be wondering. How you’re going to manage receiving 100 ounces of gold or better yet delivering it if you short the contract you may be. Able to scavenge up a few ounces of gold from your local pawn shop but the exchange may not accept second-hand wedding bands and watches as payment well while you can choose a. Future contract that does involve physical delivery of an asset a contract can be designed to instead settle in cash meaning the asset in question doesn’t actually change hands cash is simply. Debited and credited to the appropriate accounts you can also cash out of your position at any time before expiration.
By netting it against an opposite position if you short of. The gold future contract and decide to cash out halfway through you can do so by taking a long position and contract with the same underlying asset quantity and delivery. Date the two contracts will effectively cancel each other out and you will learn a profit equal to the difference in the future. Prices the reason it’s possible for future contracts be netted out is that the contracts themselves are highly standardized and trade on in exchange meaning.
It’s fairly easy to find long and short positions for a 100 ounce gold contract through your broker there are. More customizable contracts known as forwards that are directly negotiated between parties and can involve any amount of the underlying asset but these are more often used by companies looking to.
Hedge so they’re not often used by speculators so futures seem to offer a pretty convenient method for gaining the exposure to commodities but as with any investment they do come. With their own risks for one future contracts involved the use of leverage something that amplifies how much you can gain or lose from your investment we’ve discussed leverage.
In our video about shorting which you can watch for further detail but to summarize futures only require a fraction of the contracts value to be invested. By the speculator with our example if we had taken a long position in the $155,000 gold. Contract our broker would initially only require that we deposit a margin effectively some percentage of the value of the contract as a deposit on the position you may for example only need to. Have 5% of the $155,000 contract or 7750 dollars in the. Account this may seem convenient but it opens the door to pretty substantial.
Losses if gold prices fell to say a thousand dollars an ounce you would lose fifty five thousand. Dollars a 710 percent loss on your initial deposit needless to say futures are not for the inexperienced investor and while they may seem straightforward enough they maintain a vast. Array of applications they not only provide exposure to certain assets but they can be used to fundamentally alter the risk return features of your portfolio allowing investors to and remove market. Risk and even freeze returns from certain positions further yet investors use more.
Prices as an indicator of consensus estimates join investors what the market believes an asset is worth while offering insights into the assets price patterns you can visualize these patterns. With something called a future curve a graph that shows.
The for price of an asset for different contract expiration dates for gold we see an upward slope mean. That you need to pay more if you want to buy a gold at a later date.
And this curve may sometimes change to reflect changing market. Dynamics a super curve could represent an expected price appreciation and look at this future curve for natural gas notice the cyclicality this is because the price of natural gas is heavily influenced by the. Seasons more of it is purchased in the winter months when it’s used for.
Heating so for prices are higher for those periods as you can see for prices can provide quite a bit of. Information and there are many ways in which investors use them while I’ve just scratched. The surface on their applications hopefully I’ve given you enough information to broadly understand how they work futures. Are rarely part of a standard portfolio and indeed you should seek further education before investing in a contract but next time you see that tiny number in the corner of. Your screen take a moment to appreciate its significance and small glimpse into the future provides thanks for. Watching if you like this video make sure it’ll hit the like button if you.
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