One of the biggest advances in the history of commerce was the discovery that risk itself, or exposure to (in particular economic) losses, could be quantified and commodified. Some people need to minimize or even eliminate risk; others are happy to assume risk in the anticipation of greater riches. Take a cautious soybean farmer who fears he will be wiped out if prices fall, match him with a speculator willing to pay the farmer a fixed price today in hopes that prices increase, and you’ve made both parties happy. Thus, we see the benefit of having a futures market.
There are futures exchanges all over the world, offering contracts on a panoply of securities. Even the country of Nepal has its own exchanges, which means you can indeed find exchanges "from here to Kathmandu." The United States has 10 major ones, including the Chicago Mercantile Exchange (CME) as well as three others owned by its parent company. Some exchanges are designed to be very specific; for instance, the Minneapolis Grain Exchange deals only in futures for corn, soybeans and different varieties of wheat. Meanwhile, the Intercontinental Exchange (ICE) offers futures contracts for just about everything, including edibles, currencies, financial instruments and energy commodities.
If there’s a security whose price fluctuates, there can theoretically be a futures marketplace for it. Futures contracts for oil, gas, lumber and precious metals like gold and silver can all be (and are) sold today with the intention of the commodity actually being delivered months or years hence. The same goes for futures contracts for currencies, stocks and stock indices. Futures markets can seem dauntingly complex to the novice investor, and the corresponding quotes look indecipherable, but they really are not.
Futures quotes found right next to the stock quotes on the financial sites attempt to convey as much information as possible in five or so characters. For example, crude oil contracts that expired in December of 2014, trading under the symbol CLZ14. Let’s break a quote down and make sense of it, starting at the end and working our way backward.
(Screenshot of barchart.com/commodityfutures/Softs)
The last two characters of the symbol represent the year the contract expires. That’s easy enough. The third character stands for the month the contract comes due – F, G, H, J, K, M, N, Q, U, V, X or Z standing in for each of the calendar months in turn. So CLZ14 represents a contract for some commodity to be delivered in Dec. of 2014.
The first two characters of the quote represent the commodity itself. There are too many two-character codes in existence for us to list them comprehensively, but you can find almost all of them here. Most codes are intuitive. NG, natural gas. CD, Canadian dollar. OJ, orange juice, etc. There are codes for major currencies, for energy commodities (gas and oil), for grains, stock indices, meats and dairy, etc.
CL is crude oil, which trades on the New York Mercantile Exchange (NYMEX). The future’s extended eight-character code, CLZ14.NYM attests to that. (There are multiple varieties of crude oil. This particular one is West Texas Intermediate, which despite its name isn’t necessarily extracted from there. The oil comes from across North America and eventually finds its way to a storage hub in…well, not even in West Texas. The West Texas Intermediate tank farms are in Oklahoma. It can be complicated!)
At the end of trading on Sept, 12, 2014, CLZ14 closed at $90.73 per barrel. A speculator buys the contract at that price today, and if the price of oil is more than that by December, the speculator can sell his contract and profit. Whoever sells the contract today locks in the price, eliminating any chance of gains come December, and also eliminating any chance of losses. During the trading day, futures prices are quoted with a bid and an ask (offer) price, indicating the levels where a market participant is willing to buy or sell futures contracts. As a buyer of futures, you would have to buy where the price is offered for sale and to sell where prices are bid.
Even if you’re not a speculator, futures prices get interesting when we compare them to the current price of the underlying commodity. Which in this case, on Sept. 12, was $92.27.
Depending on the commodity, you can buy futures contracts for several years out. CLZ19 is available and sold on Sept. 12 for $87.08. If you look at the December futures contracts for the next few years, the trend is clear. From 90.73 they fall to 89.50, 88.37, 87.83, 87.60, 87.24 and finally 87.08. If you believe in the collective wisdom of the marketplace, the conclusion is inevitable. As to why market players think oil should get cheaper over the next few years, that’s presumably due to predicted increases in supply and decreases in demand. (Not that consumers will crave less oil and oil byproducts, but rather that the oil available then will go farther and be used more efficiently.) If you’re certain that oil will increase to $100 a barrel, you should be buying up as many futures contracts as possible.
Some commodities’ trends aren’t as pronounced. Natural gas futures trade on the same exchange and can be bought for as far as 12 years in advance. While natural gas currently sells for about $3.86 per million BTUs, NGZ26 sells for $5.49. The fluctuation is more seasonal than constant, especially when compared to crude oil, with natures gas futures prices between now and 2026 generally falling in the spring and rising in the fall.
Contracts on indices, such as the Dow Jones Industrial Average (DJIA), don’t go quite as far into the future. Dow contracts trade on the Chicago Board of Trade and are exchanged only for closing dates at the end of the quarter. The latest available contract is DJM15. That particular contract estimates a 237-point drop in the Dow level between now and then, which provides an opportunity for the undaunted speculator who’s convinced she knows something the masses don’t.
The Bottom Line
Again, you don’t ever have to partake in a futures transaction to understand the importance of futures and the information stored in their prices. But if you’re a speculator or a commodity holder, the futures market provides a place for you to find your appropriate level of risk.