CHAPTER 4: USING FUTURES MARKETS By:

Farh Mohamed Salem

OVERVIEW
• This chapter explores 3 different ways in which futures markets serve different
purposes in the market. These purposes are:

1. Futures markets provide a means of price discovery.

2. Futures markets provide an arena for speculation.
3. Futures markets provide a means for transferring risk or hedging.
2. SPECULATIONS
• A speculator is a trader who enters the futures market in search for profits and, by
doing so, willingly accepts increased risks. (Risk lover)

• There are 3 kinds of speculators which are:

1. Scalpers
2. Day traders
3. Position traders

• What differentiates the 3 types of speculators is the time horizon or the length of
time the speculator plans to hold a position.
2. SPECULATIONS
1. Scalpers
• Of all the speculators, scalpers have the shortest horizon over which they plan to hold a
future position.
• Scalpers aim to foresee the movement of the market over a very short interval, ranging from
the next few seconds to the next few minutes.
• Scalpers do not expect to make a large profit on each trade (since planned holding period is
so short).
• If prices don't move as planned: close the position and enter a new opportunity
• If trader expects the prices will go down -> Sell contracts now and buy again a few minutes
later. Similarly, If he/she expects the prices will go up -> buy contracts now and sell them a
few minutes later.
2. SPECULATIONS
2. Day traders
• Day traders attempt to profit from the price movements that may take place over the course
of one entire trading day.

• The day trader closes his/her position before the end of each trading day so, he/she has no
trading position In the futures market overnight.

• If trader expects the prices will go down -> Sell contracts beginning of the day – buy it at
the end of the day.

• If he expect the prices will go up -> buy contracts at the beginning of the day and offsetting
his position at the end of the day.
2. SPECULATIONS
3. Position traders
• Position traders are speculators who maintain a futures position overnight.

• There are 2 main types of position traders which are: outright position and spread position.

• Outright position: only requires a belief about the price movement of one commodity.
i.e., If a position trader expects the prices of gold to decrease in the future, then he’ll take a short
position in a futures contract in order to make profits if his/her expectations come true. This is the riskier
strategy.
• Spread position: Less risk than the outright position. There are 2 types of spread which are:
intracommodity spread and intercommodity spreads.
2. SPECULATIONS
3. Position traders
• Inter-commodity spread are price differences between 2 or more contracts written on different
but related underlying goods with same maturity.

• Intra-commodity spread involves differences between 2 or more contract maturities for the
same underlying deliverable good.

• More risk-averse position traders usually choose to trade spreads.

• Spread traders trade contracts with related price movements and so they speculate at
relativity of prices NOT the absolute prices.
2. SPECULATIONS
3. Position traders
• Inter-commodity spread:
The idea is to take two opposite positions on two related commodities (ex. Wheat and corn)
and offset these positions later when prices change.

• The goal is to profit from changes in relative prices.

• In spreads, we are betting that the price gap between two commodities will narrow.
2. SPECULATIONS
3. Position trader (Example on Inter-commodity spread):

July wheat contract 329.50 cents per bushel

July corn contract 229.00 cents per bushel

• Given this information, the trader believes that this difference between July wheat and July
corn is too large and accordingly, is willing to speculate that the price of corn will rise relative
to price of wheat. (5,000 bushel per contract).
2. SPECULATIONS
3. Position trader (Example on Inter-commodity spread):

Date Futures Market

February 1 • Sell one July wheat contract at 329.50 cents per bushel
• Buy one July corn contract at 229.00 cents per bushel

June 1 • Buy one July wheat contract at 282.75 per bushel

• Sell one July corn contract at 219.50 cents per bushel

• Profits or losses:
• Corn: (229 – 219.50 ) X 5,000 = $ - 475
• Wheat: (329.5 – 282.72) X 5,000 = $2,337.5
• Then total profits = 2,337.5 – 475 = $1,862.5
2. SPECULATIONS
3. Position trader (Example on Intra-commodity or butterfly spread):

Delivery Month Price (Cents per bushel)

July 67.0
September 67.5
December 70.5

• Each contract is for 25,000 bushel.

• The speculator believes that the September price should be halfway between the July and December
prices, but it’s below that level. The speculator doesn’t really know whether copper prices are going to
rise or fall.
• The goal of the speculator is to try to take advantage of this apparent discrepancy between the
different maturities.
2. SPECULATIONS
3. Position trader (Example on Intra-commodity or butterfly spread):

Date Futures Market

November 10 • Sell 1 July contract at 67 cents per bushel
• Buy 2 September contracts at 67.5 cents per bushel
• Sell 1 December contract at 70.5 cents per bushel

April 15 • Buy 1 July contract at 65 cents per bushel

• Sell 2 September contracts at 67 cents per bushel
• Buy 1 December contract at 68.5 cents per bushel
• Profits or losses:
• July: (67 – 65 ) X 25,000 = 50,000 cents = $500
• September: 2 X (-67.5 + 67) X 25,000 = - 25,000 cents = $ - 250
• December: (70.5 – 68.5) X 25,000 = 50,000 cents = $500
• Then total profits = 500 – 250 + 500 = $ 750
3. HEDGING
• A hedger is a trader who enters the futures market in order to reduce a pre-existing risk.

• If a trader trades futures contract on commodities in which he has no initial position and in
which he does NOT contemplate taking a cash position, then the trader cannot be a hedger.

• Long hedge: is a hedge in which the hedger buys a futures contract (that is, takes a long
position). (i.e., a film manufacturer, afraid that silver prices may rise unexpectedly, buys a
futures contract in order to hedge).

• A long hedge is appropriate when a company knows it will have to purchase a certain asset in
the future and wants to lock in a price now.

• If the prices goes up, the company gains on the futures and takes a loss on the asset. If prices
goes down, the company makes profit on buying the asset and take a loss on the future.
3. HEDGING
• Short hedge: is a hedge in which the hedger sells a futures contract (that is, takes a short
position). (i.e., a silver mine owner, afraid that silver prices may fall, sells a futures contract in
order to hedge).

• Short position is appropriate when the hedger already owns an asset and expects to sell it at
some time in the future.

• If prices goes up, the company gains on the asset and takes a loss on the futures position. If the
prices goes down, the company makes profit on the futures position and makes loss on the asset.
CROSS HEDGING
• Cross hedge: is a hedge in which the characteristics of the spot and futures positions do NOT
match perfectly.

• In actual hedging, it’s rare for all factors to match so well.

• In most cases, the hedged and hedging position will differ in:
• Time span covered
• The amount of commodity
• The particular characteristics of the goods