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privilege of being protected from having to sell at an unattractively low market price.
The overall advantage of selling your soybeans in the futures market is the ability to
eliminate price uncertainty.
This example imagined a futures contract from the point of view of a seller; what about
a buyer of a commodity? On the other side of the deal, a food processor that needs plenty
of soybeans for its products has the exact opposite concerns—but that is precisely why it
might want to buy this futures contract. While the farmer hopes for $10 a bushel and fears
$4 a bushel, the processor fears $10 and hopes for $4. The futures contract provides the
opportunity for both parties to protect against the potential for an unfavorable price by
giving up the potential for a favorable one. The use of futures contracts to lock in a price
in advance and protect against unfavorable prices is called hedging. Hedging can be a true
win-win for both parties to the deal. Even though it is certain in advance that one side will
end up with a less attractive price than it could have obtained on the spot market, both sides
benefit from the certainty of knowing the price to be used in advance.
There is some technical lingo that is used with futures contracts. The party that is obli-
gated to sell the commodity is said to be short that commodity. The party who is obligated
to buy is said to be long.Example 6.3.1 Andi is a futures trader who believes that there will be an extremely
large cotton crop this year, and that the price being quoted on the market for March
delivery is too high. Would Andi want to be long or short this futures contract?Andi believes that as March approaches the price of cotton will go lower. Thus, she would
want to lock in the right to sell cotton at the currently quoted (higher) price. She would want
to be short this contract.In this example, Andi is not a cotton farmer looking to lock in a good price for her crops.
She is not hedging; she is a speculator hoping to profit from an expected drop in the price
of cotton. The party on the other end of the contract may be a business such as a clothing
company that wants to hedge against the risk of rising cotton prices, or it may be another
speculator who thinks that the price of cotton is going to rise. This should raise a question
in your mind: if Andi does not actually have any cotton, how will she fulfill her obligation
to sell it in March? We will address this question shortly.The Futures Market
The term commodities market refers to the overall global activity between buyers and
sellers of commodities. This includes but is not entirely limited to the trading that occurs
at major exchanges, such as the New York Mercantile Exchange, Chicago Mercantile
Exchange, or the Chicago Board of Trade. There are many other commodity exchanges
operating in the United States and abroad; each of these exchanges trades only certain
commodities. Some examples of commodities that may be traded include natural resources
(such as gold, silver, platinum, copper, aluminum, lumber), crops (such as corn, soybeans,
cotton, coffee, cocoa beans), fuels (such as oil, natural gas, coal), and other agriculture
products (such as cattle, pigs, milk, butter).
Physical commodities like those mentioned above are certainly not the only things that
can be bought and sold, and futures trading occurs for many other things, such as kilowatt-
hours of electricity, U.S. government bonds, foreign currencies, Internet bandwidth,
and greenhouse gas emissions. The futures market and futures exchanges are broader
terms that are used to include trading in futures contracts for things that are not physical
commodities.
A futures contract could be made between any willing buyer and seller. The owner of a
coal mine and an electric utility company could directly talk with each other and make
a business agreement today for the sale of a thousand tons of coal 6 months from now at a
set price. However, the various futures exchanges function to provide a convenient way
of bringing together buyers and sellers. Rather than make direct contacts with all sorts
of potential buyers, a mine owner looking to sell coal can simply offer it for sale on an