What are commodities futures?
It is easy to find a literal definition of commodities futures anywhere on the web. Wikipedia or any online dictionary will provide a great description, but if you’re like me you’ll need a more tangible example of the principle of a futures contract. A futures contract is merely an agreement between a buyer and seller of a commodity to be delivered at a future date for a specified price. Let’s say for example that you want to purchase a new hybrid car but there’s a 10 month waiting list. The car company will promise you a car in 10 months that meets your needs if you provide a down payment of 10%. Ten months from now when the car is built and delivered you need to show up with the remaining 90% and you have yourself a new hybrid, which is convenient because the price of gasoline hasn’t stopped climbing since you put in the order for the car. This is the principle behind a futures contract. A buyer wants to secure an item at a fixed price in order to make sure the price is not higher in ten months, and a seller wants to secure a buyer at a fixed price in case demand and consequently prices should fall.
The difference between the example above and the trading of crude oil futures, coffee or corn futures, is that most of us are only looking to make money, and not to own 1,000 barrels of oil (1 crude oil contract) or 37,500 pounds of coffee (1 coffee contract). One intends to profit and to sell (or buy back if you’ve sold short) their position ahead of the delivery date on the contract. As with the example above, let’s say that because gasoline prices continue to climb, the demand for hybrid cars is increasing at a rapid rate. As demand continues to outpace supply, prices of hybrids will rise until the number of buyers willing to pay that high price equals the number of cars available. But because you had the foresight to see this trend in gasoline prices and consequently an increase in demand for hybrid cars, you have secured yourself a car at a lower price. Let’s say that your 10% down payment was for a car worth $50,000 dollars, and the price of these cars has risen in 9 months to $70,000. That means that your down payment of $5,000 dollars has already made you a profit of $15,000 dollars if you decide to sell your car to another buyer. The price difference between the current market price and your contract price is $20,000, minus the $5,000 deposit, equals $15,000 profit.
What are futures options?
An option on a futures contract is simply a contract that gives you the right, but not the obligation, to buy or sell a futures contract. In the example above you purchased a car for 10% down with the intention of taking ownership in 10 months. If you did not care about owning the car, but saw it as a money making opportunity, you could write (or sell) an option (a right to buy your contract) on your contract to someone else. Let’s say that your friend only wants your car if it is worth more than it is today. You purchased the car for $50,000, and he only wants it if he can buy it for $50,000 and sell it for $70,000 dollars. He’s willing to pay you $2,500 to own this right. If the value of the car falls in 10 months, he may choose to do nothing, because it is better to loose the $2,500 investment than to pay $50,000 for a car that is worth $40,000, realizing a total loss of $10,000. If however the price of the car does rise to $70,000 than he can exchange his option for your contract, and he’s made himself $17,500 on $2,500 in 10 months. The above example is for the purpose of clarification only. Cars are not presently traded at commodities exchanges and never will be, nor are options on them. For a list of commodities traded at the NYMEX (New York Mercantile Exchange) click here.