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The skinny on futures
What futures are and why you might want to invest in them.
Futures come in many varieties. Some examples are contracts hinged to the future performance of currencies, stocks, bonds or other assets. Insofar as a futures contract's value is contingent on the performance of another asset, these types of futures technically are a form of derivative. These can get extremely complicated. For example, some futures are contingent on the S&P 500-stock index's performance. Others are tied to foreign currencies, interest rates and precious metals.
The most traditional variety of futures is tied to commodities. These futures are contracts that commit the investor to deliver or receive a quantity of specific good -- anything from pork bellies to live cattle to apples -- at a price determined by auctions held at a futures exchange.
As with options, time is of the essence. Futures holders have a set amount of time to decide what they're going to do. Unlike stocks, futures can't be bought and left unattended for years. In this sense, they can be a nerve-wracking asset to own. Popular exposure to commodity futures came in the movie "Trading Places," in which Eddie Murphy and Dan Aykroyd gave the villains their comeuppance through buying and selling futures in frozen concentrated orange juice. They retired wealthy after a quick hit. If only it were that easy!
The amount invested in the futures contract is called the margin. The price of the commodity itself is due when the contract expires. At this point, investors theoretically would take or make delivery of the commodity concerned.
Does this mean that if you invest in futures, you'll someday find a huge pile of pork bellies on your lawn with an astronomical invoice attached? Hardly.
Almost no one actually takes or makes delivery (and those who do use warehouses). Before the contract expires, you can do what's known as "squaring your position" by paying or receiving the difference in the current market price of the commodity versus the price stipulated in your contract.
So, if few people are actually taking or making delivery of commodities, you might ask why this market exists in the first place. The answer is to spread risk. For example, pork producers have a pretty precise idea of what it will cost them to raise today's piglets into tomorrow's pork chops. What they don't know is how much these chops are going to be selling for when the grown pigs are slaughtered, in part because they don't know what the supply will be. That's where investors come in. In buying pork futures, they buy a piece of the risk that those in the industry face when they make long-term investments in their livestock.
Despite the important economic role of futures, this investment is approached by many as though it were radioactive. Indeed, futures can be risky, chiefly because they are highly leveraged investments, meaning that large amounts of a given commodity can be controlled with a small margin investment. Margin, after all, is essentially a performance bond stating that you assume the financial risk of the commodity's volatile price. So you can be on the hook for amounts far greater than you've invested.
Of course, this leverage works both ways: By investing small amounts, you can reap huge profits quickly. Or you can lose your shirt just as fast. Indeed, your chances of coming out ahead aren't statistically good. Some studies have shown that twice as many people lose money in individual futures as make money. Such findings have prompted experts to advise investors to stay away from futures unless they have some money to burn, as they would for a trip to Las Vegas or Atlantic City.
Yet there are some aspects of futures that are not as austere. Futures funds, if well managed, are less risky than picking individual futures. Allocating a small percentage of your assets to a respectable futures fund may serve as a helpful form of diversification for your portfolio, even if the returns are low. Click here to get to Money 101's lesson on asset allocation.) One warning, though -- get a qualified adviser to help you evaluate funds.
Also, keep in mind that not all futures investing is speculation. There are two forms of futures investors--speculators and hedgers. Speculators use the leverage of futures to try to score large profits, while hedgers use the market to offset, or hedge, risks to other types of investments in their portfolios. Using judicious futures investments as a hedge over the long haul can provide portfolio protection with returns that are lower but much more predictable than a speculator's.
After you gain enough experience to choose individual commodities, choose prudently, and don't get sucked in by low prices. Too many investors spread their futures money over too many commodities -- more than they could possibly research or understand. Commodities with higher margins may cost more to get into, but that's because their value is less volatile. As with bonds, lower prices mean higher risk.
Above all, keep in mind that to win the game, you need the right marbles. The main reasons that individual investors lose money on futures are that they are under-informed, under-capitalized, and undisciplined (and so let their egos rather than their original plans control their trading). Experience also counts for a lot. The best way to get experience is to practice futures trading on paper -- hardly a test of your emotional mettle in situations where real money is concerned, but helpful for getting a handle on the mechanics of investing in futures.