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Why Futures Markets Are Important

Investing fads run in cycles. Before the late 1990s, relatively few people had their own brokerage accounts; the mutual fund was the investment of choice for the investing masses and was sufficient to meet most of their needs. As the Internet bubble inflated, suddenly everyone was talking about the prospects of their favorite brand-new tech stock, and technology centers like Silicon Valley, Seattle, and Austin found themselves awash in cheap money. Since the Internet was the source of so much wealth, it only made sense that investors would look to Internet-based online brokers to help educate them on how to get their piece of the pie.

At the time, many established full-service brokers argued that this was the worst possible thing to happen to small investors. By allowing inexperienced people to bypass the oversight of licensed professionals, they argued, Internet trading would only succeed in getting people into trouble and threatening to turn the American public into a horde of crazed gamblers, sure that whatever ticker symbol they entered into their trading platform would turn to gold.

You all know how that turned out. But just because the vast majority of Internet-related companies had terrible stock performance in the aftermath of the technology bubble, that didn't spell the end of the Internet as a valuable tool. Indeed, although talking about individual stocks at cocktail parties has probably declined in popularity, discount brokers like Schwab (Nasdaq: SCHW  ) have helped to make computer-based stock trading the most cost-effective way to invest in individual stocks.

Now, performance-chasing investors have turned their attention to commodities. After spending two decades bouncing around without much direction, gold prices started to move up quickly in 2002, eventually reaching peaks nearly three times their lows. Skyrocketing oil prices meant pain at the gas pump for consumers, but it made big profits for speculators in the oil futures pits. More importantly, it got many investors thinking about an asset class they had never before studied closely.

How commodity futures work
Although trading commodity futures successfully can take a lot of detailed understanding and experience, the idea behind commodity futures is extremely simple. Say you're a farmer planning your production for next season. You estimate that unless you have a catastrophic growing season, you'll be able to grow 1,000 bushels of corn and harvest it next October. Without commodity futures, you'd have to wait until next year and then try to sell your harvested corn in the cash market. That leaves you exposed to the risk that prices will move down sharply over the course of the next 12 months, reducing your potential profit or even turning it into a loss. Of course, if prices move up, then you'll do better than you expected, but often rising prices reflect bad conditions that could affect the quantity of your crop production. If you could lock in a price now but not have to deliver your corn until next year's harvest, you would know exactly what to expect to receive at harvest time and eliminate the risk of falling prices.

On the other hand, say you're a rancher who uses corn to feed your cattle when necessary. You know that next October, your cattle won't be able to count on summer grasses for grazing, and you'll need to buy 1,000 bushels of corn to make it through the winter. Like the farmer, you could wait to see what the price of corn is next year, but if prices go up, you may not be able to afford the corn. If you could lock in a price this year, you'd know what to expect and eliminate the risk of rising prices.

The commodity futures markets allow people like this hypothetical farmer and rancher to lock in prices on goods that will be delivered at a future date. The rancher could buy a futures contract, promising to pay a certain fixed price in exchange for 1,000 bushels of corn to be delivered next October. Similarly, the farmer could sell a futures contract, promising to deliver 1,000 bushels of corn next October in exchange for a certain fixed price. These two transactions are sometimes called hedging transactions, because both parties reduce the risk of losing money if prices move against them. A large volume of hedging transactions occurs in the futures markets, involving pairs of parties like farmers and food processing companies, oil drillers and oil refineries, foreign businesses earning U.S. dollars and U.S. businesses earning foreign currency, and mining companies and jewelry producers.

Speculation and commodities
As you can see, commodity futures are a valuable tool that certain businesses depend on to reduce their risk. However, because futures contracts can be bought and sold nearly every day, those who buy or sell futures contracts are not required to actually buy or sell the physical commodity involved. For instance, if you believe that the current estimate of next year's corn prices is too low, then you can buy a futures contract for delivery next year. If prices move up between now and then, you will make money; you can then sell the futures contract to someone else before the delivery date. As a speculator, you can use the commodity futures markets to take advantage of moving prices without ever having to worry about what to do with 1,000 bushels of corn, 1,000 barrels of crude oil, or 1,000 ounces of silver bullion.

Speculators often end up being the scapegoats for large fluctuations in prices, such as the recent rise in energy prices over the past two years. However, in many markets, the volume of speculative activity is minuscule in comparison to hedging activity among producers and consumers. Also, as an additional source of liquidity in the futures markets, speculators can make it easier for businesses in a particular industry to make hedging transactions; instead of having to wait for another related business to agree to be the counterparty, one can use the speculator's willingness to assume price risk to get the hedging transaction done more quickly.

Investing in commodities may be popular right now, but it's still important to understand that the commodity futures markets aren't just a casino for speculators; they serve a valuable function for a wide variety of businesses. By understanding the futures markets and how they work, you can look at headlines touting commodity performance from an educated perspective.

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Curious about whether commodities should be part of your retirement savings strategy? Rule Your Retirement'sRobert Brokamp has worked to find answers to this and other questions his newsletter readers ask. Taking a free look with a 30-day trial is easy.

Fool contributor Dan Caplinger has dabbled in the futures markets with mixed results. He's enough of a coin collector to have some precious metals at home, but he doesn't own shares of Schwab or any of the futures contracts mentioned in this article. The Fool's disclosure policy is good as gold.


Read/Post Comments (1) | Recommend This Article (3)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 08, 2009, at 4:58 PM, davidkubica1 wrote:

    Motely, I am suprised you didn't bring up managed futures programs. They are an easy way to diversify across futures. Most professionals receommend that 20% of your portfolio consist of managed futures. Try this website: www.managedfuturesdepot.com . These guys have some great managed futures programs with excellent returns. Especially be sure to look at http://www.managedfuturesdepot.com/shadrachprogram.php . Since their invesption over five years ago this program has averaged a return of over 8% per month.

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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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