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So Trader Bob and Trader Sam get together and agree upon a price for
widget. Trader Bob is now proud owner. If value of widget indeed increases in future, then Trader Bob can become a seller and part with widget with a profit. If value of item decreases in future then Trader Bob will have to sell widget for a loss.
This basic relationship between buyer and seller is foundation for all commerce. Futures are simply a variation on this theme, where instead of buying a widget now, Trader Bob contracts to buy widget in a few months at a fixed price. The transaction still relies on buyer believing price will go up, and seller believing price will go down.
Trading Critters
Futures traders fall into two categories: hedgers and speculators. The primary economic purpose of futures market is for hedging, which is buying or selling futures contracts to offsets risks of changing prices in cash markets. Hedge traders, such as large commercial firms that may actually take delivery of certain commodities, like coffee or wheat, use futures contracts to protect (hedge) themselves against changing cash prices.
Speculators, however, make up majority of futures traders. Speculators have no commercial interest in underlying commodity and have no interest in taking delivery of commodity. The potential for profit is what motivates speculators to trade commodity futures. Speculators buy when they believe that prices will increase and they sell when they believe that prices will fall. Futures traders using STARS would be considered speculators.
Basic Basics
If a trader is a buyer, he has taken a long position. A long position involves purchase of a futures contracts in hope that price of contract will increase in future. Let’s say our friend Trader Bob contracts in March to buy a widget (a long position) in June for $10. June rolls around, and price of a widget is now $13. That means Bob now has right to buy widget for $10 even though going rate is $13. Bob goes ahead and buys widget for $10, then turns around and immediately sells it for $13, pocketing difference.
A trader who is a seller takes a short position, which involves sale of futures contracts in anticipation of prices falling in future. Trader Bob in this case contracts in June to sell a widget in September for $13. Fall comes around, and going rate for widget in September turns out to be $9. Trader Bob buys a widget for that going rate of $9, then immediately turns around and exercises his right sell widget for $13, profiting from difference. At first, it might seem odd that Trader Bob is contracting to sell something he does not yet own. But look at situation this way instead: in June, Bob makes a commitment to sell a widget to Sam in September for a guaranteed price of $13. If Bob can buy widget for less than that sometime before September, he will make a profit.
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Copyright © Jeff Schweitzer
PERMISSIONS TO REPUBLISH: This article may be republished in its entirety free of charge, electronically or in print, provided it appears with included copyright and author’s resource box with live website link.
Jeff Schweitzer received his Ph.D. from UCSD in 1985. Jeff was appointed as a science advisor at the White House under the Bush and Clinton Administrations for three years before devoting attention to generating wealth through trading futures. He has published more than 60 articles in diverse areas, including neurobiology, marine science, international development, environmental protection and aviation.
