THE CHICAGO COMMODITIES PROBE : A Primer : Why Futures Exist and How They Work

What is a futures contract? What is a futures margin account? What is hedging?

If you don’t know the answers to these questions, you are not alone. Futures markets are among the most important--but least understood--facets of our economy. And attention to them has increased sharply in the wake of revelations that federal investigators have uncovered massive fraud among brokers at the Chicago Board of Trade and the Chicago Mercantile Exchange, two of the nation’s biggest futures exchanges.

Here is a primer on how the futures markets work:

QUESTION: What are the commodities markets?

ANSWER: Think of the 12 commodity markets operating in the United States as you would the New York or American stock exchanges. However, this is not a place where stocks are bought and sold. Instead, the trading is in “futures contracts” for a variety of agricultural products--wheat, corn and pork bellies are among the best known--and financial instruments, such foreign currency and Treasury bonds.

Q: Why do these markets exist?

A: In the beginning, the commodity markets were created to protect farmers from unexpected and uncontrollable fluctuations in the prices of their crops. These days, however, more than just farmers want to protect their positions, and the commodities markets have expanded. For example, banks, insurance companies and pension funds can protect themselves from interest rate fluctuations by participating in futures contracts offered on Treasury securities.

Typically there are two groups of people who enter into futures contracts: speculators and hedgers. Speculators want to profit from fluctuating prices; hedgers--including farmers--want to protect the market value of their commodities.

Q: What is a futures contract?

A: Futures contracts are financial commitments between two parties for the delivery of a specified amount of a certain commodity at a specific date in the future. The specifics of these contracts are set by the markets on which they trade. Contracts generally range in value between $10,000 and $40,000 and can reach as high as $1 million, but participants rarely put up the full amount. Instead, they make a deposit, typically 10% to 20% of the contract’s value. The deposit is known as margin, and the account in which this money is held is called a margin account.

A key point to remember is that only 3% of the commodities that are the subject of these contracts are ever exchanged, notes David Shimko, assistant professor of finance at USC. These futures contracts are not about taking possession of a commodity; they are about protecting a price position in that commodity.

Q: How do these futures contracts work?

A: Let’s go back to the farmer. A wheat grower who must get $4 per bushel to break even on his crop can be wiped out if an oversupply of wheat at harvest drives the market price down to $2 a bushel.

However, he can protect himself against falling prices by getting into a wheat futures contract requiring him to deliver 100,000 bushels of wheat at $4 per bushel on a certain date. Although he has no intention of actually selling his wheat to the buyer of his futures contract, he has effectively locked in a $4-per-bushel return. If the price of wheat drops to $2, he will sell his wheat to the mill for the market price, but because of his contract, his loss at the mill is offset by his gain on the futures contract. He’s a happy farmer.

A speculator, however, who believes that wheat prices are on the rise can make money by investing in a $4-per-bushel contract and waiting for the contract to rise in value as wheat prices rise. If a drought severely damages a portion of the wheat crop and the bushel price of the remaing crop rises to $6, the speculator on this contract has scored a big win.

In general, the speculator’s winnings are paid by the farmer. Here’s how it works: The farmer sells his wheat for $6 a bushel at the mill. But his apparent $2-per-bushel profit must be used to cash out his original futures contract. By the time the dust settles, the farmer gets $4 per bushel and the speculator has made a $2 per bushel profit.

Q: How can you participate in the futures market?

A: If you’re a farmer, your local bank may allow you to sell contracts through its hedging service. Speculators--and this definitely includes the average investor--can get into the market in a variety of ways. Your stockbroker can open an account for you in one of the commodity markets; you can invest in a commodity futures pool that is similar to a mutual fund; or, if you can meet the minimum financial requirements, you can open your own trading account on one of the exchanges.

Typically, you must maintain a cash balance in your account equal to 10% to 20% of the value of the contracts in which you’ve taken a position. It sounds easy, but it isn’t. The value of the contracts in every trader’s account is totaled at the end of every trading day, and the accounts are credited and debited by the amount the contracts fluctuated during the day’s trading. This practice is called “marking to market.” So if the wheat contract fell one cent per bushel and your contract was for 100,000 bushels, your account is debited $1,000 and the farmer’s account is credited with $1,000. If the deduction causes your account to fall below margin requirements, you will be asked to deposit additional funds.

Q: Why are futures so risky?

A: You can lose far more than your original investment. Through margin accounts, you only have to put up a small fraction of the total value of the contracts you trade. But if the price of the commodity or financial instrument declines by a certain amount, you may be subject to a “margin call” requiring you to put up more cash to maintain your margin account.

Because of margin, a decline of just a cent in the price of a commodity could mean that you lose hundreds or thousands of dollars. If the price falls far enough, you could lose your entire initial investment plus additional money you invested to maintain your margin account. On the other hand, a rise in price could mean you earn far more than you invested. Many investors enter commodities with the hope of hitting enough big winners to more than offset losses on other trades, but as much as 90% of individual investors lose money in the futures market.

Futures also can be risky because prices can move quickly after unpredictable events, such as changes in weather conditions. Individual investors generally don’t have immediate access to such information, putting you at a considerable disadvantage to professional traders who can follow and act on events on a minute-by-minute basis.

Q: How are futures ripe for fraud?

A: Fraud can occur on trading floors when futures brokers manipulate or misrepresent prices to customers to pocket part of the profits entitled to investors. This practice is central to the current federal investigation of trading practices at the Chicago Board of Trade and Chicago Mercantile Exchange.

Fraud also is rampant when unscrupulous brokers or other salespersons misrepresent the riskiness of commodities investments, usually through telephone pitches to unsophisticated investors. Earlier this week, for example, federal charges were filed against 18 former employees of First Commodity Corp. of Boston, alleging that they defrauded more than 2,600 investors of $23 million. The defendants were charged with using high-pressure sales tactics to persuade customers to invest in high-risk commodity ventures that they misrepresented as low risk.

Q: How are futures regulated?

A: The futures markets are principally regulated by the Commodity Futures Trading Commission, an independent federal agency that critics contend is more lax than the Securities and Exchange Commission, which regulates stocks.

The various futures exchanges also oversee member brokerage firms that trade on those exchanges.

HOW A COMMODITY TRADE IS MADE 1. A customer places an order with a broker. The broker completes an order slip. That slip must be stamped showing the exact time the order was received from the customer.

2. The broker phones the order to a clerk or other staff person on the floor of the exchange where the trade must be executed. The clerk also prepares an order slip which must also be time stamped.

FRAUD OPPORTUNITY: The broker never executes the trade, instead pocketing the customer’s money. This practice, which is rare, is called “bucketing.”

3. The clerk takes the order slip to a floor broker in a “pit” where the particular commodity or financial instrument is traded.

The floor broker executes the trade through an “open outcry” system of trading. In that system, the broker uses hand signals and shouts to communicate his trade (whether he wants to buy or sell, how much and what price). Another broker or trader willing to make that trade signals or shouts back, and the deal is made.

Once the trade is completed, the brokers must record that on their order slips. They also must signal to a price reporter at that pit who records the trade and in turn reports that to the exchange’s clearing operation. The clearing operation makes sure that all trades are matched up (each buy order must be accompanied by an identical sell order, and vice versa). Trades that are not matched up must be reconciled before the next day’s trading.

FRAUD OPPORTUNITY: Brokers and traders may miscommunicate in trading with each other, or may err on the terms of their trades. Because these trades still must be reconciled through the clearing process, brokers may misrepresent trades to customers to avoid eating any losses.

Brokers and traders also may collude with each other to manipulate the price of their transaction, allowing them to skim some of the profit entitled to customers.

4. The floor broker gives the order slip, with information about the completed trade, is given back to the clerk who in turn calls the original broker who took the customer’s order. That broker informs the customer that the trade has been completed. The broker also may be required to report the trade to the exchange’s clearing operation.

FRAUD OPPORTUNITY: The brokers may misrepresent the trade to the customer, saying that they sold the commodity at a price of $5 when in fact the trade was made at $6. The broker pockets the difference.

Brokers also could “replace” the customer’s trade with another identical trade made for their own accounts at another time of the day that was less profitable. The brokers claim the more profitable trade for themselves and sock the customer with the less profitable transaction.