Reply #25: How much intestinal fortitude do you have? [View All]

[jmowreader]

If you have serious guts and can afford to lose your ass, consider futures contracts.

When you buy a futures contract, you are saying that on a specified date future you promise to purchase x amount of a commodity for y amount of dollars. Let's throw out two numbers: 1000 ounces of gold for $400 per ounce for January delivery.

The futures contract itself is salable; people sell futures contracts all of the time.

You are buying a futures contract because you are betting the price of gold will be more than $400 in January. The people who sold it to you are betting it will be less than $400. (And they're really gambling here--a lot of the time the seller doesn't own the gold himself.) Buying futures has limited risk and unlimited reward--all you can lose is $400 per ounce (this assumes they're giving it away) but selling them carries limited reward but unlimited risk--there is a possibility that gold could do what the spammers keep saying it will and hit $2500 per ounce, and when that contract comes due you still have to pony up a thousand ounces of gold for $400k.

If on date future, assuming you held the contract to maturity, the spot price of gold is $600, you're in high clover--you come in with your pickup and your armed guard, turn over your $400,000, receive your thousand ounces of gold and sell it to someone else at the spot price--the amount of money you must pay to receive your gold "on the spot."

OTOH, if you hold to maturity and the spot price is now $300, you still must pay $400,000 for that gold. Now you have a slight dilemma: no safe deposit box in the known world will hold 83 pounds of gold. (There are 12 troy ounces in a pound, not 16.) You will have to pay someone to safeguard all of this gold until you recover your $100,000 setback, or you'll have to take a $100,000 hit.

Options contracts are less of a gamble: on date future, you have the option of purchasing 1000 ounces of gold for $400 per ounce. If gold is enough higher than $400 to recover commissions and the options contract, go ahead and buy; if not, don't. There's still the risk/reward thing going on here, but it's far less on the buyer's side; you don't have to lose your ass if you don't want to.

Right now you're wondering why in hell anyone would do futures. They were invented for ag trading. A food manufacturer can buy futures for all their ingredients and be able to do accurate financial planning. To them, this is worth any risk involved in futures contracting. (Besides, if you planned around $4/bushel wheat and it went to $4.05, five million bushels would cost you an extra $250,000. How many people do you know who remain employed after missing a financial target by a quarter million dollars?) Gold futures make sense for someone like Jostens, Motorola or Intel, who use gold in their products.

Everyone else who wants to play the commodities-futures markets should do options. There's less risk that way.