Futures markets - why

THE REASONS OF PREFERENCE OF THE FUTURES MARKETS


The futures markets are preferred due to three reasons:
- to have an opinion about the future price of the commodities

- to hedge his investment

- to speculate



TO HAVE AN OPINION ABOUT THE FUTURE PRICE OF THE COMMODITIES

By using the futures markets , the investors can have an opinion about the price of the commodities in the future. Because of the delivery obligation of the commodities is undertaken, the futures price of this commodities reflects its expected spot price at the expiration date. Everybody can be informed of the futures prices and can decide about their investment. For example , the great firms use the futures markets when they plan their cash flow for the commodities which can be stored. The firms which decide the amounts of their inventory according to the expectations about the supply and the demand provide the stabilized distribution of the commodities and prevent the manipulation in the markets.

By having an opinion about the price in future ,the firms can plan their production cost cheaply and can use their economic sources more effectively. So the equilibrium between the supply and the demand can be kept. For example if the futures price of one commodity is high, the producers will aim to produce this commodity and the quantity of the supply will be brought on the sufficient level. If the futures price of one commodity is low ,the producers will not produce unnecessarily, so they will increase their productivity and will decrease the storage cost.

HEDGING


The most important goal of the use of the futures markets is to hedge (to protect against unfavorable price changes). The investor take equal but opposite position of his spot position in the futures markets. That is , the investor who is in the short position (selling) in spot market take a long position (buying) in the futures markets ; the investor who is in the long position (buying) in spot market take a short position (selling) in the futures markets. The aim of these operations is to equilibrate his loss in one market with the profit in an other market. Due to the supply and the demand , the cost of the price uncertainty will be reduced by hedging.



Houthaker’s opinion is that the uncertainty is a result of the time difference between the production and the consumption . In this period the wrong expectations about the level of the production and the consumption create the price fluctuations. There are two types uncertainties : the social uncertainty and the personal uncertainty.

In the social uncertainty the persons know their quantity of the production and the consumption ,but they don’t know what they will do and how the price will change because they don’t know the quantity of the others’ production and consumption .

In the personal uncertainty , the persons can’t know their quantity of the production and the consumption. Due to hedging , the risk of hoarding a large amount of stock can be reduced. The producer can reduce his risk of the price decline of the commodity that he hasn’t got yet , (for example the wheat on the field ), by selling a futures contract. This is called a short hedge.

The producer ( or the investor) ,for example a textile firm which use the cotton as a raw material , can reduce the risk of the spot price increase of the cotton by buying a cotton futures contracts. This is called a long hedge. The investor who hedge assume the basis risk instead of the price risk. Because of the different pricing methods of the futures contracts according to spot prices ,the variation of the basis value creates the basis risk. The basis value is defined as the difference between the futures price and the spot price.

If the investor hedges by using a different but related futures contract (that is, the commodity which is the subject of the futures contracts is not the same with the commodity that the investor want to hedge) this is called cross hedging. This time there is a cross hedging risk. But this risk is lower than the spot price risk . The futures markets can reduce the research costs and accelerate the knowledge flow. This particularity can help to the hedgers.



TO SPECULATE

To trade in futures markets by assuming the risk of the hedgers with the goal of having a gain is called to speculate. That is, the risk is transferred from the hedgers to the speculators. The speculators take the speculative position when they are aware of the difference between the futures price and the expected spot price in the future.

If they believe that the futures price of one commodity is lower than its expected spot price which will occur in the future , they buy the futures contracts in futures markets ; if they believe that the futures price of one commodity is upper than its expected spot price which will occur in the future, they sell the futures contracts in futures markets. If their predictions are true , the speculators obtain a gain.

The role of the speculator is to benefit from the supply and demand relation of the hedgers by predicting correctly. The hedgers use the futures markets to disperse the risk and they are willing to pay the money over its real cost.

Due to the presence of the speculators the supply and demand of the hedgers can be covered. The absence of the speculator reduce the liquidity of the market . This can cause to not cover sufficiently the supply and the demand of the hedgers. Despite the fact that they create the instability in the markets, the speculators secure that the difference between the futures and spot price were in determined level . The transactions of the speculators create a resistance point when the prices are reduced ,and a support point when the prices increase. For the purpose of the gain the speculators prefer the markets which have the sufficient liquidity and which provide the sufficient safety for applying the contracts clauses.

There are two kinds of the speculation : the speculation which is based on the supply - demand news and the speculation which is based on the trends of the prices.

The speculation based on the supply - demand news
The speculators who realize this kind of the speculation are the price level traders and the news traders .

Price level traders are interested in the news and the documents which help them to judge the price level. A speculator who thinks that the wheat price will decrease before the harvest period and then it will increase slowly is an example of this speculation kind.

News traders are interested in the news which indicate the expected supply and demand variation. These speculators who acquire the news don’t wait before they trade. Their waiting period is less than the price level traders. Both of these speculators don’t execute their own transactions in the exchange floor ; they aim to hide their knowledge from the other investors so they realize their transactions from their office .

The speculation based on the anticipation of the price trend
The speculators who realize this kind of the speculation are the scalpers and the position traders .

The scalpers realize their transactions in the short intervals such as few minutes. These speculators buy when the prices decrease and they sell after few minutes when the prices increase . Holding period is so short that their gain are small. The scalpers trade with their sensation without looking at the economic indicators . They have the theories that show the formation of the futures price in five minutes. These speculators trade themselves for the purpose of not losing their gain because of the brokerage fees. Their basic attitudes are to understand the traders’ feelings in the floor .

The scalpers are classed as unit-change scalpers , day trading scalpers and day to day scalpers.

For unit-change scalpers the meaning of the change is the minimum price change at the time when they are operating. Their aims are to buy 1/8 cent below (or to sell 1/8 cent above) the last price.

Day trading scalpers try to gain by trading during the day. The value of the overnight positions is lower than the value of the intraday transactions. They think that the overnight positions are risky. For example the price of the crops which are damaged because of the inundation can increase and the trader who has an overnight position can lose because of this situation.

Day to day scalpers carry on their positions during a few nights. The duration of their positions are from half day until three days.

The second kind of the speculators who are based on the anticipation of the price trend are position traders. These speculators carry on their positions during the weeks and the months. For example if a position trader believe that the price of one commodity will decrease , he will sell the futures contracts . If his expectations come true he will gain by taking the reverse position . If not, he will lose money.