Futures - Help me understand
Discussion
Ok, lets say I have some tulip bulbs 
for sale at £1.00. I get contacted by a trader who will buy them off me in the future for the price of £1.50. This covers the cost of storage etc etc so I do the deal. So a futures contract is entered into and I promise to deliver my tulip bulbs on the specified date and the buyer has to pay on the same date. Now this part I udnerstand but its the payment that I don't quite grasp. I understand that the exhange will take money out of the margin account or put it in depending on loss or profit daily but its this mechanism I can't quite get my head around. Can someone explain it in thicko terms please. How is it done daily? Why not at the end of the contract date?
for sale at £1.00. I get contacted by a trader who will buy them off me in the future for the price of £1.50. This covers the cost of storage etc etc so I do the deal. So a futures contract is entered into and I promise to deliver my tulip bulbs on the specified date and the buyer has to pay on the same date. Now this part I udnerstand but its the payment that I don't quite grasp. I understand that the exhange will take money out of the margin account or put it in depending on loss or profit daily but its this mechanism I can't quite get my head around. Can someone explain it in thicko terms please. How is it done daily? Why not at the end of the contract date? I am a little rusty but...
He agreed to pay £1.50 in the future for something "worth" £1 today.
You have to think about what needs to happen the day you deliver the bulb.
He gives you the £1.50 you give him the bulb.
BUT since the bulb is worth £1 (mark to market) then he only needs £0.50 cash to do the deal - he can sell the bulb immediately for £1 cash (assuming that the bulb is still worth that on that day).
Now consider that the bulb drops in value before you deliver it.
He still needs to find £1.50 but he is only receiving something worth 50p, not the £1 it used to be worth.
So he needs to find £1.00 in cold hard cash, not just the 50p.
Conversely the bulb might double in value - so instead of needing to find 50p to pay you, he can sell it for £2, give you the £1.50 he owes and pocket 50p profit.
Taking money out or putting it in to his account up to the vesting date just marks the value of the bulb to market (the price that day).
He agreed to pay £1.50 in the future for something "worth" £1 today.
You have to think about what needs to happen the day you deliver the bulb.
He gives you the £1.50 you give him the bulb.
BUT since the bulb is worth £1 (mark to market) then he only needs £0.50 cash to do the deal - he can sell the bulb immediately for £1 cash (assuming that the bulb is still worth that on that day).
Now consider that the bulb drops in value before you deliver it.
He still needs to find £1.50 but he is only receiving something worth 50p, not the £1 it used to be worth.
So he needs to find £1.00 in cold hard cash, not just the 50p.
Conversely the bulb might double in value - so instead of needing to find 50p to pay you, he can sell it for £2, give you the £1.50 he owes and pocket 50p profit.
Taking money out or putting it in to his account up to the vesting date just marks the value of the bulb to market (the price that day).
What you are describing isn't really a futures contract. Futures are exchange traded you don't know or care who holds the long to your short position, you just have an obligation to deliver at a certain point in time.
To play on an exchange you need some initial margin (varies by contract according to volatility mainly) before you can open a position. Every day the profit or loss on your positions will be calculated, if you're in profit your margin account goes up, conversely if you're making a loss your margin account goes down. If your margin account goes below a certain level (maintenance margin) they'll ask you to top it up, if you can't make the margin call to top up your account you surrender your position. In theory someone else then buys your position (at the current market price), you've lost some money, the exchange loses nothing and the person/people holding the oposing position are in profit or may even have sold the position multiple times.
Edited to add: What you might be referring to is a forward contract, whereby the terms are entirley up to the delivering and recieving parties to decide, there maybe margin/collateral requirements, then again there may not.
To play on an exchange you need some initial margin (varies by contract according to volatility mainly) before you can open a position. Every day the profit or loss on your positions will be calculated, if you're in profit your margin account goes up, conversely if you're making a loss your margin account goes down. If your margin account goes below a certain level (maintenance margin) they'll ask you to top it up, if you can't make the margin call to top up your account you surrender your position. In theory someone else then buys your position (at the current market price), you've lost some money, the exchange loses nothing and the person/people holding the oposing position are in profit or may even have sold the position multiple times.
Edited to add: What you might be referring to is a forward contract, whereby the terms are entirley up to the delivering and recieving parties to decide, there maybe margin/collateral requirements, then again there may not.
Edited by greggers on Thursday 6th June 14:07
walm said:
I am a little rusty but...
He agreed to pay £1.50 in the future for something "worth" £1 today.
You have to think about what needs to happen the day you deliver the bulb.
He gives you the £1.50 you give him the bulb.
BUT since the bulb is worth £1 (mark to market) then he only needs £0.50 cash to do the deal - he can sell the bulb immediately for £1 cash (assuming that the bulb is still worth that on that day).
Now consider that the bulb drops in value before you deliver it.
He still needs to find £1.50 but he is only receiving something worth 50p, not the £1 it used to be worth.
So he needs to find £1.00 in cold hard cash, not just the 50p.
Conversely the bulb might double in value - so instead of needing to find 50p to pay you, he can sell it for £2, give you the £1.50 he owes and pocket 50p profit.
Taking money out or putting it in to his account up to the vesting date just marks the value of the bulb to market (the price that day).
Its that last sentence that gets me. He agreed to pay £1.50 in the future for something "worth" £1 today.
You have to think about what needs to happen the day you deliver the bulb.
He gives you the £1.50 you give him the bulb.
BUT since the bulb is worth £1 (mark to market) then he only needs £0.50 cash to do the deal - he can sell the bulb immediately for £1 cash (assuming that the bulb is still worth that on that day).
Now consider that the bulb drops in value before you deliver it.
He still needs to find £1.50 but he is only receiving something worth 50p, not the £1 it used to be worth.
So he needs to find £1.00 in cold hard cash, not just the 50p.
Conversely the bulb might double in value - so instead of needing to find 50p to pay you, he can sell it for £2, give you the £1.50 he owes and pocket 50p profit.
Taking money out or putting it in to his account up to the vesting date just marks the value of the bulb to market (the price that day).
On a Monday the trader agrees to buy the bulb on Friday at £1.50
Tuesday the bulb costs 0.90
Wed it is now worth 1.20
Thursday its worth 1.10
Friday the bulb is worth £1.50
So how does this daily margin thing work? He still owes £1.50 on Friday but has been making a loss or a profit daily over the week. Or do I have the complete wrong end of the stick here. Does he just stick 50p into his margin account and hope, come friday he has enough so as to not default?
greggers said:
Edited to add: What you might be referring to is a forward contract, whereby the terms are entirley up to the delivering and recieving parties to decide, there maybe margin/collateral requirements, then again there may not.
Quite possibly but as I have just been readin Peter Garbners Tulipmania it made sense to use the tulip reference as they where at the time specified asset and came in standard quantity (ass LOL)Edited by greggers on Thursday 6th June 14:07
Edited by Sexual Chocolate on Thursday 6th June 14:27
Greggers is describing what happens when you really try to execute one of these trades on an exchange.
I am trying to describe whether the trade has made or lost money at a given point in time.
I think you are confused by being somewhere in the middle!!
The real money an exchange takes out of your account is more to do with their rules about collateral as Greggers says.
The running P&L is a more theoretical number that is simply the difference between the current value of the commodity and what someone has agreed to pay for it.
It only becomes reality at the point of exchange.
I am trying to describe whether the trade has made or lost money at a given point in time.
I think you are confused by being somewhere in the middle!!
The real money an exchange takes out of your account is more to do with their rules about collateral as Greggers says.
The running P&L is a more theoretical number that is simply the difference between the current value of the commodity and what someone has agreed to pay for it.
It only becomes reality at the point of exchange.
walm said:
Greggers is describing what happens when you really try to execute one of these trades on an exchange.
I am trying to describe whether the trade has made or lost money at a given point in time.
I think you are confused by being somewhere in the middle!!
The real money an exchange takes out of your account is more to do with their rules about collateral as Greggers says.
The running P&L is a more theoretical number that is simply the difference between the current value of the commodity and what someone has agreed to pay for it.
It only becomes reality at the point of exchange.
And now it makes sense. So the P & L are theortical and if the trader decides to pull out half way through the week that theoretical P & L is no no longer theoretical. Got you! I am trying to describe whether the trade has made or lost money at a given point in time.
I think you are confused by being somewhere in the middle!!
The real money an exchange takes out of your account is more to do with their rules about collateral as Greggers says.
The running P&L is a more theoretical number that is simply the difference between the current value of the commodity and what someone has agreed to pay for it.
It only becomes reality at the point of exchange.
Next week... Market Bubbles, and do they really exist or are they just an effect of mass pyschology
Sexual Chocolate said:
And now it makes sense. So the P & L are theortical and if the trader decides to pull out half way through the week that theoretical P & L is no no longer theoretical. Got you!
Next week... Market Bubbles, and do they really exist or are they just an effect of mass pyschology
Correct ish.. Next week... Market Bubbles, and do they really exist or are they just an effect of mass pyschology
some brokerages will require you to have a maintance margin which reduces their risk profile, in that case you will see your p&l physically in the reduction of your margin account, but it would not be realised untill you close the position.
z4chris99 MSc Finance and Investment
I don't think any of the tulip versions so far realy explain it. For a start you have to pay for an option.
You are selling tulips for £1.40. The trader knows he's going to need more next week when he thinks supplies will be short and the price will be about £1.50. He buys an option to purchase tulips at £1.50 next week, and pays you 10p per tulip for this option.
Come next week, tulips are trading at £1.30, so he doesn't exersice his option, no tulips change hands and he got nothing for his 10p. You're 10p up but still have the tulips.
Or maybe come next week tulips are trading at £1.70 so he exercises his option and buys them and he's up on the deal.
Or maybe tulips are trading at £1.70 but he doesn't actually need them any more. So he sells the options for 15p each. The buyer gets his tulips for £1.65 so he's cool. The trader gets 15p for options he paid 10p for, so he's 50% up on that deal, with ever actually buying any tulips.
Effectivley, options provide a high leverage on your investment so you can make much more, but also put your capital at high risk. You might double your money or lose it all. If you bought actual tulips you might make or lose 7%.
You are selling tulips for £1.40. The trader knows he's going to need more next week when he thinks supplies will be short and the price will be about £1.50. He buys an option to purchase tulips at £1.50 next week, and pays you 10p per tulip for this option.
Come next week, tulips are trading at £1.30, so he doesn't exersice his option, no tulips change hands and he got nothing for his 10p. You're 10p up but still have the tulips.
Or maybe come next week tulips are trading at £1.70 so he exercises his option and buys them and he's up on the deal.
Or maybe tulips are trading at £1.70 but he doesn't actually need them any more. So he sells the options for 15p each. The buyer gets his tulips for £1.65 so he's cool. The trader gets 15p for options he paid 10p for, so he's 50% up on that deal, with ever actually buying any tulips.
Effectivley, options provide a high leverage on your investment so you can make much more, but also put your capital at high risk. You might double your money or lose it all. If you bought actual tulips you might make or lose 7%.
On a Monday the trader agrees to buy the bulb on Friday at £1.50
Tuesday the bulb costs 0.90
Wed it is now worth 1.20
Thursday its worth 1.10
Friday the bulb is worth £1.50
I think the bit you are missing is that whilst the guy may have agreed to pay 1.50 for the tulip bulb and has to stump up that on Friday, the market price may not be 1.50. So his daily MTM will cover the loss he has made from the agreement with you.
R11ysf said:
Why would anyone need an option? Futures contracts can be traded on their own. No options complications needed.
The advantage of an option it that is gives choice and limits the down side.Contract 1 at no cost I agree to buy your tulips at £1.50 next month, this means I have to buy your tulips at £1.50, I can not cut out of the deal
Contract 2 I buy an option off you to buy your tulips next month at £1.50, I pay 5p a tulip to you up front for the option.
Next month....
Situation 1 Tulips are at £1.70 on contract 1 I buy of you at £1.50 and am 20p up per tulip, contract two I take up my option to buy at £1.50 and due to having paid 5p per tulip upfront I am 15p per tulip up.
Situation 2 Tulips are at £1.20 on contract 1 I have to buy at £1.50 and am down 30p per tulip. On contract 2 I tear up my option and am down just the 5p per tulip.
The option works as an upfront cost to limit future risk. For the person selling the option it is an upfront profit on creation of a future risk.
Sexual Chocolate said:
Ok, lets say I have some tulip bulbs for sale at £1.00. I get contacted by a trader who will buy them off me in the future for the price of £1.50. This covers the cost of storage etc etc so I do the deal. So a futures contract is entered into and I promise to deliver my tulip bulbs on the specified date and the buyer has to pay on the same date. Now this part I udnerstand but its the payment that I don't quite grasp. I understand that the exhange will take money out of the margin account or put it in depending on loss or profit daily but its this mechanism I can't quite get my head around. Can someone explain it in thicko terms please. How is it done daily? Why not at the end of the contract date?
YOU ARE CONFUSING FORWARD AND FUTURES contracts. I think. for sale at £1.00. I get contacted by a trader who will buy them off me in the future for the price of £1.50. This covers the cost of storage etc etc so I do the deal. So a futures contract is entered into and I promise to deliver my tulip bulbs on the specified date and the buyer has to pay on the same date. Now this part I udnerstand but its the payment that I don't quite grasp. I understand that the exhange will take money out of the margin account or put it in depending on loss or profit daily but its this mechanism I can't quite get my head around. Can someone explain it in thicko terms please. How is it done daily? Why not at the end of the contract date? If a trader contacts you and agrees to buy a fixed quantity, at a fixed price, at some point in the future that is a FORWARD contract. Such as if you said 'Condi, I will sell you my car in 6 months for £1000'. Fine, we have a deal. If the price of cars goes up 10% then tough - you still owe me that car for £1000. Similarly if the price goes down I still pay the £1000.
If you buy a FUTURES contract on the exchange you may well have no idea who the other person is. In my example, I would buy a Futures contract of 1 car, expiring in 6 months time. It costs me £1000 today. You sell a futures contract for £1000, expiring in 6 months time. This all happens over the exchange. Me and you never have to meet.
Now, if the price goes up by £100 in one day then I would have made 100 should I sell my contract back onto the exchange. You would have lost 100. So the broker takes £100 out of your margin account and puts it onto the exchange. The exchange then takes that £100 and gives it to my broker who puts it in my margin account. This happens every day for 6 months, with the price going up and down and money moving in and out of margin accounts.
In reality at the end of the contract if I have made £300 I am likely to try and sell my futures contract back to someone else, pocketing the £300 profit and buy a physical car from Autotrader. If you wanted you can tender your car into the exchange and someone ie who has bought a contract will take delivery of it. The chances are you will never know who bought your car. The vast majority (99%+) of futures contracts never go to delivery though - they are always closed out. Hence futures markets are not very often used for the buying of physical goods. They are there to manage risk. Speculators use them as well, but their primary function is to manage and offset risk in markets.
Options, spreads etc are needlessly complicated when you dont understand the basics. Options in particular are very dangerous beasts if not used correctly. Used badly they expose you to almost unlimited downside with a very small return. Think of them like insurance - lots of us BUY insurance, but only a very few big boys have the capital to SELL insurance. Used well they can be a good, if expensive, tool to protect yourself from adverse movements.
Edited by Condi on Monday 10th June 20:50
Edited by Condi on Monday 10th June 20:55
otherman said:
Effectivley, options provide a high leverage on your investment so you can make much more, but also put your capital at high risk. You might double your money or lose it all. If you bought actual tulips you might make or lose 7%.
Im not quite sure you know anything other than very basic A level/university understanding of options if thats your attitude. Options are not something for 'anyone' to play with. Plenty of individuals, and companies, have lost an awful lot when options have been used badly. Viking cereals for example. Whole company went bust because of one trader. 
JPBailey said:
The advantage of an option it that is gives choice and limits the down side.
As with all exams JP read the F**king question. The OP asks about FUTURES and after it seemed to have been answered fairly well then someone jumps in with a very average description of an option. I was pointing out that options have nothing to do with futures unless you want them too. But thanks for the GCSE definition and examples.....
Whoa, some touchy responses here!
To be fair to the fella you did say why would 'anyone' need an option?
As I'm sure you know mate options cover a wider range of commodities so that is one reason right there. Before we even go into the certainty of downside and the various other reasons why someone might choose an option over a future.
But anyway, the reason people dont often ask about this stuff is because they dont want to be made to look stupid so lets keep it civil shall we!
To be fair to the fella you did say why would 'anyone' need an option?
As I'm sure you know mate options cover a wider range of commodities so that is one reason right there. Before we even go into the certainty of downside and the various other reasons why someone might choose an option over a future.
But anyway, the reason people dont often ask about this stuff is because they dont want to be made to look stupid so lets keep it civil shall we!
Gassing Station | Finance | Top of Page | What's New | My Stuff