Futures markets allow investors to buy or sell a specific amount of a commodity (such as gold, pork bellies or heating oil), or financial instrument (Treasury bills or a stock-market index) at a particular price in a stipulated future month.
By buying a futures contract, you can control a fairly large investment with a fairly small amount of money. That’s because you’re allowed to use “leverage"--a fancy term for making a purchase with a very low down payment. A $1,000 investment, for example, might buy you a contract for $20,000 worth of wheat. If wheat prices rise just 5%--a gain of $1,000 on your contract--you’ve just doubled your money. However, if they drop by the same amount, you lose your $1,000 investment.
Worse still, if prices drop more than 5%, you could lose far more than your initial investment. If your wheat contract suddenly was worth just $10,000, you lose $11,000--the $1,000 you put in initially plus the $10,000 investment loss, plus any brokerage fees you paid.
Many professional traders use the futures markets to hedge risk. If they plan to buy a huge amount of pork bellies in the future, they can buy a futures contract to protect themselves in case the price of bellies rises or falls by the time they want to take delivery.
Only about 5% of futures trades now involve agricultural products, which in the 1970s accounted for three-fourths of all trades. Currently, most futures trades involve financial instruments.
One thing hasn’t changed: The vast majority of traders lose money in the commodities markets, says David Gary, a spokesman for the Commodities Futures Trading Commission in Washington. Roughly 80% of all the people who invest in commodities come out losers after trading costs are taken into account, he says.