I feel ridiculous that I can’t even understand this seeming simple idea, but I need some clarification in regards to how a hedging buyer or seller gains/profits in the futures market and how the relationship between the spot price and the futures price.
As I understand it, if I was a farmer selling coffee fearing prices will fall in March I could essentially buy a position now (in November) to sell coffee in January for a predetermined price, let’s say $10/bu, and be able to “lock in” that price. That price will be the futures market price for coffee in March, in November. When March comes along prices happen to fall as I predicted. So I actually lose money right? So, in fact, if I wanted to sell I wouldn’t get a futures contract if I suspected prices to fall, correct? I would want a futures contract to buy, right?
So, in that case in the following months (Dec. – March) am I looking to see if prices are moving up. So lets say in Dec. the spot price is $11/bu and the December’s futures price for March is $12.50. Then January the spot is $11.20 and the futures price for March is $12.55 and both prices keep rising. Finally, March comes and the spot is $11.80 and the futures price is $12.62. Am I selling at $1.80/bu profit? Why would there be a spot price and futures price for the same month? In other words, why would there be a need for a March futures price when there’s a current spot price for March?
Any help is greatly appreciated. Assume you’re explaining this to a 3rd grader and I should get it. Thanks in advance.
actually this is quite simple once you see it.
if you are a producer that will be harvesting coffee in mar and in nov. you see that the mar. futures price is $10/bushel. If you think that this is a good price, then you hedge your crop by selling enough march coffee futures to equal your expected crop size. Then in march you will buy mar. coffee futures to close out your position. If coffee prices are greater than $10, then you will lose the difference plus expenses and if coffee prices are lower than $10 then you will make the difference minus your trading expenses. You will also be selling your physical crop of coffee for the same or very nearly the same as what you got for the futures, as the futures and spot prices will converge as you approach settlement date.
if you took a loss on the futures transaction (ex. mar coffee goes for $12.00) you will pick up this gain on the physical transaction. likewise if you take a gain on the futures transaction (ex. mar. coffee goes for $8.00) it will offset your loss on the physical transaction.
the hedge is not exact because you will always have transaction expenses from the futures transaction. also the spot price when you sell physicals might not be exactly the same as the futures price if there is any time left on the futures.
to put it simply you will get approximately $10 for you crop in march (this is net – futures and physical combined) regardless of whether the price of coffee is $0.00 or $10.00 or $25.00. this is the idea of the hedge, that you can sell your crop for a known amount before harvesting it and as a result you won’t care what happens to prices.
Commodities price keep increasing, who are the speculators ? Who are the victims? How these bloody speculators play able to paly in the money games ?
Who are these heartless peoples who are earning billions of dirty money from the poors?
Why no politicians, mass media, economists, people with common sense voice out the truth of these dirty games or try to stop them?
Why all of them still lying to us? Giving us all kind of unrealistic information?
Why until today, there are no proper rules in banks, financial instutions and laws to prevent these type of bad intention speculating in all kinds of commodities, exchange rates…?
There are so many types of future options have been created by banks, financial institutions, trading campanies,…
Why until today, there are still no proper control in speculating using these tools call future options and they still name it hedging, free trade, ….?
I dont think the first answer posted here actually answered your question. It also seemed to be a sort of rant. I'm not an economist but I will give it a try:
It does seem offhand that speculation is what is driving the prices of commodity futures higher, especially oil and now some agriculture products. A knee-jerk reaction would be to step in as the govt. and fix prices on commodoties or pass some law to hurt or stop speculators. There are several problems with that approach:
1) Which govt? If the US govt. steps in and stops speculation on US exchanges for commodities, why wouldnt speculators just buy commodities futures from other exchanges? There are exchanges all over the world that trade commodity futures. The US is the big dog on the block so it may help some but then again there are other issues….
2) The US economy is in a downturn or recession or just plain feeling low. If the govt. stepped in and squashed the one area where investments are gaining it could have repercussion in other areas of the economy and make things even worse. For example, banks that heavily invested in real-estate are in a tailspin but that crash landing may be dampened by investments in commodities that gained money. If that gets taken away, it could mean the crash landing simply becomes a crash. That would be bad for the entire economy and make things even worse for the poor.
3) The media is whipping up food prices by causing hysteria. The more CNN and others bellow about the "Food Crisis" as if we are all one ego away from starving, the more speculators think "Hey! prices are going to go even higher!" In the grand scheme of things, food has not gotten that much more expensive (at least in the US, not sure about other countries). White bread is up 16 cents since last year. that sort of thing. Percentage-wise it may be a 20% increase or something but pocket-book wise its 16 cents. There was a story on CNN recently about a poor mother of 2 kids who made her own detergent. She had to because she washed like 12 loads of laundry a day or something like that. Not sure what detergent prices has to do with food prices but CNN featured that as an example of how we are all on the verge of starvation.
4) As is often quoted when it comes the the market: "what the wise do in the beginning, fools do in the end. " Speculation is a self-correcting aspect of the market. Just ask farmers and oil men. There is plenty of oil and food to go around. The big investors will shift their dollars out of commodities once there is something better to invest in and there will be a big correction. Just like with the internet bubble and the housing bubble. When your third-cousin Billy-Joe starts talking about investing in gold or oil because he heard its a good investment, look for the bubble to pop.
The idea of speculation, "market forces" (whatever the hell that means), bubbles, etc… may sound like a terrible way for "heartless" people to make money. But in reality it has been the best way to make sure everyone gets a piece of the pie. Once governments start price-fixing, shortages abound. In some really bad cases like Zimbabwe or Venezuela, the price fixing gets to a point that it simply doesnt make any sense for the farmer to grow some crops.
I agree with you that speculation in commodity markets can hurt people (high gas/food prices) and there should be some regulation to how its done but the ideal way to stop speculation is to have an incentive to move your money somewhere else. If US stocks start going up a lot of investors will shift their dollars to the stock market. Or if interest rates go up in the US, dollars will be put into treasury bonds. Right now the investment returns are in commodities, but dont worry. The commodity bubble will eventually 'pop' and people will look towards fundementals in those markets.
http://www.globalchange.com UK house price trends. While house prices may fall or rise in short term, prices are generally stronger than they would otherwise be because of shortage of land, planning restrictions, more people living alone, crisis of confidence in pension funds so people investing in property instead… plus other factors such as immigration. Complex area. Video comment on real estate by Dr Patrick Dixon, futurist and author of Futurewise, including buy to let, property investment funds. (more)
The Commodity Futures Modernization Act allows oil to be traded on unregulated markets. This has allowed speculation (investment without intent to use oil) to drive up oil prices to where they are today. (read this: http://www.atimes.com/atimes/Global_Economy/JE06Dj07.html
Ron Paul voted against the Commodity Futures Modernization Act, While Bill Clinton signed it into law.
Nancy Pelosi also voted for this bill. So did anyone else you can think of.
Ron Paul is 1 of 4 congressmen who voted against it and what is now called the Enron Loophole.
Just another example of leadership by Ron Paul that demonstrates he is not owned by the corporations.
He is the only person worth voting for
This article on oil pricing should be front page news all across America.
It explains exactly why gas/fuel prices are high, when they shouldn't be.
Mrs. Clinton was involved in a commodities scandal way back in Arkansas when Bill Clinton was Governor, if my memory is correct.
She made millions of dollars trading, and people suspected she had insider trading information. { a tip on future commodity pricing }
You see the markets are now not dependent on the supply demand factor,,,they can be bid up by buyers with big bucks, using margin requirements, to be way, way, higher than the supply demand factor would allow,,,,
They also can be bid down by sellers selling short contracts. { A short means only a promise to sell at some time in the future. }
Ron Paul may be the only congressman that would expose this FRAUD, because many of the others are getting rich from knowing insider information!!!!
http://www.globalchange.com UK house price trends. While house prices may fall or rise in short term, prices are generally stronger than they would otherwise be because of shortage of land, planning restrictions, more people living alone, crisis of confidence in pension funds so people investing in property instead… plus other factors such as immigration. Complex area. Video comment on real estate by Dr Patrick Dixon, futurist and author of Futurewise, including buy to let, property investment funds. (more)