Apologies for the delay in this post - I've been busy getting the fund up and running in the midst of some traveling. My visa only allows me to stay in mainland China for 90 days at a time, so every now and then I'm 'forced' to take a trip somewhere else. This time I'm visiting a friend at his beach house on an island in Thailand called Koh Phagnan. It was a bit of an adventure to get here, but well worth it - I can't say I mind looking at palm trees and sipping coconut water while I work! I'm happy to report that the fund is up and running and doing just fine so far. Check back this weekend for our first weekly update.
Anyway, I hope this introduction to futures trading will provide a general idea of what exactly it is we do. Most people - even financially the savvy - don't really understand futures markets or hold incorrect assumptions about it.
Ever see the movie Trading Places? (Major spoiler alert here, though you should still find and watch it anyway.) I won't bother with most of the movie, since it's the final scene that's relevant to us, but basically the two main characters, Louis Winthorpe III (Dan Aykroyd) and Billy Ray Valentine (Eddie Murphy) come up with a way to ruin the Duke brothers, wealthy commodities traders who have done them wrong. The Dukes arrange to get a sneak peak at an important government crop report, but Winthorpe and Valentine intercept the report en route (the movie came out in 1983, so no e-mail) and replace it with a fake. The climactic scene shows what happens:
So, what happened there? Clearly, Winthorpe and Valentine get their revenge and make plenty of money in the process (the movie's closing scene shows the two relaxing on a tropical island, which I can relate to). But very few people actually understand the mechanics of what happened.
Let's take a step back and talk about what everyone in that room is yelling about in the first place. The "last bastion of pure capitalism" is in fact a commodities exchange, where futures contracts and other commodities-related products are traded. A futures contract - the most commonly traded security at these exchanges - is essentially a promise to deliver a certain amount of a certain, standardized commodity on a certain date. In the movie, the action is centered around the April contracts for frozen concentrated orange juice, meaning that according to the rules of the exchange, someone who sells a contract is expected to deliver a set quantity (15,000 lbs) of a certain type of frozen concentrated orange juice (US Grade A) to the buyer of that contract at the end of the delivery month (April). Note that the term futures contract by definition indicates the contract has these sorts of specific attributes and is traded on an exchange where buyers and sellers are largely anonymous. Contracts dealing with irregular types of goods or contracts negotiated between two parties directly are called forward contracts or forwards.
These sorts of contracts arose out of the need of producers of commodities to protect themselves against price fluctuations. For example, let's say that you're a farmer deciding which crops to plant. Even if you know how much wheat or corn you can produce per acre, it's hard to choose if you don't know what the price will be come harvest time. So you sell a contract promising to deliver your goods at harvest time for a certain price, thus locking in your profits and mitigating your exposure to a change in prices. This practice is called hedging, and producers of commodities who sell contracts of this sort are called hedgers. On the other side, you have speculators, who buy contracts with the hope of benefiting from a change in price. Generally speaking, the utility of a futures contract is that it allows the transfer of risk from a hedger, who is more risk-averse, to a speculator, who is more risk-seeking. That's the basic distinction, though there are certainly exceptions and overlaps. For example, consider a cattle farmer, who might buy a futures contract for corn to lock in his feed costs, and then sell a contract for cattle to lock in his profit.
Modern exchange pits like the one in the movie (they still do it like that at most major exchanges) may seem chaotic, but that's because they concentrate all of the world's risk into one room! Indeed, things would be much more chaotic if farmers and miners and other producers had to plan out their projects years in advance with no ability to hedge their risk to price fluctuations. Given the relatively straightforward origin of futures contracts, it should be no surprise that they're nothing new; Aristotle mentioned a primitive sort of contract that had been created for dealing with olive oil production. Modern commodities exchanges have existed for over 300 years, starting with rice trading in Japan. Commodities trading has been present in the US since its founding and has played an integral role in the country's economic development.
But anyway, back to the movie. The Dukes have been slipped a fake crop report, which says that the bad winter has negatively affected crop yields. This would result in a higher price for orange juice (reduced supply, higher price), so the Dukes' trader starts buying a lot of orange juice contracts right from the start. This is called a long position, meaning that the Dukes purchased securities with the anticipation that the price would rise. Other traders notice this, assume the Dukes know something, and join the buying party. That sends the price sky-high. But Winthorpe and Valentine know what the real crop report will say (the orange crop was unaffected), so they wait for the price to rise, and just when demand is at a peak, they start selling. They're banking on the true crop report sending the price lower; if they sell contracts when the price is high, and then the price drops, they can buy the contracts back at a lower price and keep the difference as profit. This is called a short position, meaning that they sold something they didn't have with the anticipation the price would decrease.
It's important to note that they sell contracts for orange juice they don't have - no way they have hundreds of thousands of pounds of frozen concentrated orange juice lying around. Unlike an orange farmer, they just created a bunch of orange juice out of thin air. But remember that the contract is just a promise which says they have to deliver the orange juice at the end of April. The scene in the movie takes place in January, so as long as they buy back the contracts before April, they won't actually have to find however much orange juice they wrote promises to deliver. They won't owe anything and will simply have gained or lost the difference in the value of their contracts in between. The number of contracts "outstanding" is called the open interest. Whenever someone sells a new contract and someone else buys that contract, the open interest increases. If the opposite happens, i.e. if someone who wrote a contract buys one back off the market to close out their position, the open interest decreases. At the end of the expiry month, the outstanding contracts are settled, either through physical delivery of the commodity or simply exchanging cash.
Anyone can "write" or "create" a futures contract, and then "destroy" it by buying that contract back. That's a very important difference compared to other securities, such as stocks or bonds. A company issues those instruments, which are also a kind of promise or liability, but after they're first issued they're traded between people who have no obligations to one another. If you own a bond and sell it to someone else, you don't have anything to do with repaying the bond upon its maturity - it's still an obligation of whoever issued the bond, not of the buyer or seller. But if you sell a futures contract for orange juice, you are legally obligated to come up with 15,000 lbs of orange juice (unless you had previously bought a contract, in which case your sale of the contract just closes out your existing position). On the other hand, this means it's considerably easier to enter a short position in futures than it is to do so with stocks or bonds.
So the crop report comes out shortly after Valentine and Winthorpe have sold a bunch of contracts at high prices, which were driven up in the first place by the Duke brothers. Indeed, the winter did not affect crop yields, and the surprised market turns around in a jiffy (remember, everyone had assumed that the Dukes knew something, so they were expecting the crop report would indicate a weak harvest). The price drops precipitously, and again in the midst of panic, Valentine and Winthorpe step in. This time, they buy back all the contracts they just sold, thus closing out their position (so they won't actually have to come up with all that orange juice they promised). Now that the price has collapsed, they keep the difference in the value of the contracts, thus profiting immensely. On the other hand, the Dukes, who held a large long position and were unable to sell it off in time, are ruined.
But that's only part of the story. At the end of the scene, a man from the exchange walks up and informs the Dukes of a margin call for close to $400 million. Well, what's that mean? Maybe you've heard of margins in the context of buying stocks "on margin," but with futures contracts it has a very different meaning. In order to buy a futures contract, you don't actually have to pay the full value of the contract. Let's say orange juice is trading at 100 (i.e., $1.00 per pound). Each contract is for 15,000 lbs, so the value of each contract is $15,000. But when you buy a futures contract on a commodities exchange, you only have to put down a fraction of the contract value, called the initial margin, to be able to trade that contract. This margin fluctuates with the value of the contract, but is generally quite small compared to the contract value - usually less than 10%. You only have to put down the remaining value of the contract if you actually want to take delivery of the commodity. Contrast this to stock trading, where even if you're borrowing money from your broker to buy a lot of shares, that money has to come from somewhere; you (or your broker) can't just pay for 10% of the value of the stocks you want and then come up with the rest later.
The ability to control contracts worth vastly more money than you have is called leverage, and it can be your best friend or worst enemy. If the initial margin is 10% on an orange juice contract, you only need $1500 to buy a contract that's worth $15,000. If the price rises from 100 to 120, the value of the contract increases to $18,000. When you sell the contract, you get your initial margin back and keep the difference in the value of the contract, since that's what you're actually trading. So just like that, you can make a 200% return - $3,000 profit on a $1,500 investment! For simplicity's sake, we'll stick with 10% for the movie example (since we don't know exactly what it was that day). Let's say you're one of the traders who saw the Dukes buying up contracts and you jump in for 100 contracts at 140. The value of those contracts is 100 x $1.40 x 15000 lbs = $2,100,000, but at 10% the initial margin is only $210,000. The crop report comes out and the price drops precipitously. You try to sell but there just isn't anyone buying, and you have to wait until Winthorpe and Valentine start buying back contracts to cover their short position after the price has dropped
a full dollar per pound, to 40. Well, since each contract is for 15,000 pounds, that means the value of the contracts has dropped by $1,500,000. When you sell the contracts, you get your initial margin back, but your loss is this difference - more than seven times the money you put down! You can see how easily it is to get into serious trouble, and how the Duke brothers end up losing their shirts. Of course, you can also see how Winthorpe and Valentine ended up on a tropical paradise by taking the opposite position.
To at least partially mitigate this danger, there are a variety of rules and regulations to protect all the different parties involved. First, exchanges (and/or your broker) also require you to maintain a certain cash balance in your brokerage account, called the maintenance margin, which is usually set at roughly 70% of the initial margin (it varies considerably depending on the specific contract). Let's say you pay $1,500 for an orange juice contract trading at 100. Let's say the maintenance margin is $1,050. This means when you buy a contract, you actually shell out the initial margin of $1,500, but you need to maintain an additional $1,050 in cash in your account as long as you hold the contract. If the price suddenly drops from 100 to 96 - not a very big change - the value of the contract drops from $15,000 to $14,400, implying losses of $600. Subtracting from the initial margin of $1500, the remaining balance of $900 is below the maintenance margin of $1,050, so your broker (or the exchange) would make a margin call, demanding that you either liquidate the position or restore your account balance back to $1,500, where it started. That's what happened to the Duke brothers, but on a much larger scale.
Also, the exchange sets position limits so no one player can corner the market or get into too much trouble. What happened to the Dukes would probably not happen in real life. While it's possible to take out a very large position, the exchanges don't want any one player to jeopardize the integrity of the market or the solvency of the exchange in case of a default. For example, the current position limit for orange juice contracts is 300 contracts per delivery month. In addition, the exchange sets limits on how much the price can fluctuate in a day. Trading can continue in most cases if the price reaches the daily limit, but it can't exceed that limit. For example, the limit for orange juice is ten cents up or down. If the open was 102, as in the movie, the price for the day can only move between 92 and 112. So the situation in the movie with a move from 142 to 29 in a matter of minutes isn't possible in real life.
However, the scene in Trading Places provides a nice example of many aspects of futures trading. It's worth noting that the scene was filmed on the floor of a real exchange at the World Trade Center in New York (since destroyed on 9/11), and they used real traders (on an off day), so it's pretty authentic.
Alright, that's a pretty comprehensive introduction. Feel free to ask if you have any questions. Down the line, I'll do a few more "educational" posts about futures trading in general and our strategies for navigating the markets.