Risky Business: How the Futures Markets Work
The arrival of federal agents on the floors of four New York commodity exchanges Thursday drew public attention once again to the risky and little-understood world of futures trading.
The morning raids took place at the offices and trading pits on the eighth and ninth floors of a tower at the World Trade Center in lower Manhattan, where five New York exchanges trade futures on commodities ranging from oil to frozen orange juice.
The exchanges involved in Thursday’s activity--the New York Mercantile Exchange, the New York Commodity Exchange, the Coffee, Sugar and Cocoa Exchange, and the Cotton Exchange--are among 12 such exchanges operating in the United States. They operate something akin to the better-known New York or American stock exchanges
Instead of trading stocks, however, these financial markets deal with the trading of “futures contracts” for a variety of products, such as agricultural commodities, precious metals, foreign currencies and Treasury bonds.
The contracts are bought and sold on sprawling floors by traders shouting orders in chaotic pits, which are monitored by officials from the individual exchanges and the Commodity Futures Trading Commission, the federal agency that regulates such activity.
Although Chicago’s exchanges are the largest, New York’s exchanges are growing. The New York Mercantile Exchange has gained prominence with its crude oil, gasoline and heating oil contracts, and the Commodity Exchange is best known for its gold and silver trades.
Futures trading brings together two highly divergent groups: hedgers, such as farmers, bankers and utilities, who want to protect the value of their commodities in changing markets, and speculators, who don’t hold the commodities but hope to turn a profit on the price swings.
The futures contract is an agreement, usually between a speculator and hedger. The contract specifies how much of a commodity will be delivered, and at what price, on a specific date some weeks or months hence.
Contracts cover a standard amount of a commodity, say 100 ounces of gold or 40,000 pounds of pork bellies; the value can range from $10,000 to $1 million. But a participant need put down only a small percentage of a contract’s value, an amount called the margin, before settlement, in which the goods are exchanged between buyer and seller. Only about 3% of the contracts actually are settled with an exchange of the commodity.
A wheat grower, for example, who needs $4 a bushel to break even can protect himself against falling prices by getting into a futures contract that requires him to deliver 100,000 bushels of wheat at $4 each on a specified date to a speculator who buys the contract.
Although the grower may have no intention of actually selling his wheat to the speculator, he has guaranteed himself a $4-a-bushel price. He may sell his wheat to the mill at market prices. But even if that price has fallen to $2 a bushel, the grower’s loss is offset by his gain on the futures contract.
The speculator in this example, meanwhile, is betting on the price of wheat to increase. Say a wheat shortage causes the price to rise to $6 a bushel. In the end, the farmer still breaks even by receiving $4 a bushel and the speculator takes the $2 profit.
Thus news of droughts, oil spills or other events that may affect future supplies of traded commodities can send futures prices careening wildly up and down from hour to hour.
Though potential profits from such trading are impressive, the risks are quite high as well. Because of the way the futures markets work, a swing of just a penny in the price of a commodity could mean the loss of hundreds of thousands of dollars to the speculator.
It has been estimated that as many as 90% of individual investors who venture into the futures markets come out losers.
The average investor “should definitely stay away from them,” said Peter Ritchken, an associate professor of finance at USC. “They are taking a lot of risk.”
