There is a glossary of terms at the end of this book, but let’s take this opportunity to acquaint ourselves with some of the more common futures terminology.

Bull Market

A bull market is a market in which prices are rising. When someone is referred to as being bullish, that person has an optimistic outlook that prices will be rising.

Bear Market

A bear market is one in which prices are falling. Therefore, a bearish view is pessimistic, and that person would believe that prices are heading downward. Going Long If you were to buy a futures contract to initiate a position, you would be long. A person who has purchased 10 pork belly futures contracts is long 10 pork belly contracts. Someone who is long in the market expects prices to rise. They expect to make money by later selling the contracts at a higher price than they originally paid for them.

Going Long

If you were to buy a futures contract to initiate a position, you would be long. A person who has purchased 10 pork belly futures contracts is long 10 pork belly contracts. Someone who is long in the market expects prices to rise. They expect to make money by later selling the contracts at a higher price than they originally paid for them.

A more difficult concept involves the sale of futures contracts before buying them. Someone who sells a futures contract to initiate a position is said to be short — for example, short 10 pork belly contracts would mean that a person initiated a position by selling those 10 contracts. But don’t confuse this concept with someone who originally went long by purchasing futures contracts and is now selling them to offset his or her position in the market. A short seller has entered into an obligation to deliver a commodity at a future date, at a price agreed upon today, but with the ability to offset that obligation by buying back the futures contract. As a short seller, you believe that prices are heading downward, so you sell futures contracts that you think will be less valuable sometime in the future. If things go as you anticipated and the market does head downward, you can then buy back those same contracts at a lower price and make a profit. The transaction is in reverse, but you can still make money the old fashioned way — buy low, sell high. Let’s take a hypothetical example of how this would work in real life in a forward market scenario. Johnny and Jill are playing in the park on Saturday afternoon. Johnny tells Jill that he would pay $10 if he could get his hands on a genuine professional baseball. Jill (who aspires to be a futures trader some day) can recognize an opportunity when she sees one. Jill tells Johnny that she will sell him that pro baseball for $10, but asks if Johnny can wait until tomorrow to give it to him. Johnny agrees and hands over the $10 to Jill, thus entering into a forward sale. The next day Jill runs over to the local sports store, buys the baseball for $6 and delivers it to Johnny. Jill walks away with a $4 profit, having sold the baseball before she purchased it. Now you can see how short selling (selling something before you’ve actually purchased it yourself) can work! Contract Maturity Futures contracts have limited lives, known as contract maturities. Contract maturity is expressed in terms of months, such as December. The contract maturity designates the time at which deliveries are to be made or taken, unless the trader has offset the contract by an equal, opposite transaction prior to maturity. Futures contracts are typically traded up to one year into the future, while some commodities may trade more than two years into the future (e.g., CME Eurodollar futures). Many contracts expire quarterly — specifically towards the end of March, June, September and December. For simplicity, the months are assigned alphabetical codes. Delivery Only about 3% of all futures contracts actually result in physical delivery or cash settlement of the commodity. The other 97% are simply offset. That means that the majority of participants close out their positions prior to the contract’s delivery date (sellers buy back the futures they sold, and buyers sell back the futures they bought). For some futures contracts, such as stock index futures, there is no physical delivery. Rather, positions are closed out through cash settlement. On the day following the final trading day, open contract positions are settled in cash with no deliveries of the securities. The full value of the contract is not transferred to your performance bond account. Instead there is a final “marking-to-the-market” of the contract position to the actual index based upon the opening values of the stocks, with the final gain or loss applied to the performance bond accounts. With this cash delivery feature, liquidity is ensured to the last day of trading of the contract. Why would the remaining 3% of traders make or take delivery? They would do this primarily for two reasons: » The buyer or seller actually has need for the product to be bought or sold. Farmers and homebuilders are examples. » The locked-in futures price is better than what they could get elsewhere in the marketplace.

Hedge

If you “hedge,” you buy or sell a futures contract as a temporary substitute for a cash market transaction to be made at a later date. Hedging usually involves holding opposite positions in the cash market and futures market at the same time. Hedging is a business management tool used to manage price risk.

Long Hedge

If you put on a “long hedge” you purchase a futures contract in anticipation of an actual cash market purchase. Processors or exporters typically use long hedges as protection against an increase in the cash price. Example: An American cruise line facing increases in the price of the Euro (currency) could put on a long hedge in CME Euro FX futures to minimize the price risk they face. The long hedge would enable the cruise line to purchase the Euros at the lock-in price of the futures, even if exchange rates do in fact rise.

Short Hedge

To put on a “short hedge” you would sell a futures contract in anticipation of a later cash market sale. Traders use short hedges to eliminate or lessen the possible decline in value of ownership of an approximately equal amount of a cash financial instrument or physical commodity. Example: In contrast to businesses that need to purchase commodities, such as airlines, other businesses produce or harvest commodities to sell, and therefore worry about price decreases in their commodities rather than price increases. Thus, commodity producers, such as farmers, put on “short hedges.” A farmer, for example, who needs to sell his crops at a certain price in order to make a profit, will attempt to lock in a reasonable price for his crop through a short hedge, to protect himself against too low a price in the cash markets at harvest time. It is important for all people who hedge, either through long or short hedges, to realize that while hedging can provide price protection for them, there is also a “cost” involved. If the hedge succeeds and they minimize their price risk, they also sacrifice a possibly greater return than they would have had had they not hedged. The hedge provides a type of insurance for them, but also determines the price at which they will buy or sell the commodities they are trading.

Speculator

You would be considered a “speculator” if you bought and sold futures contracts for the sole purpose of making a profit. Speculators attempt to anticipate price changes. They do not use the futures markets in connection with the production, processing, marketing or handling of a product, and have no interest in making or taking delivery. Review of Futures Trading and Price Discovery Before we go learn any more terminology, let’s take a moment to review the concept of futures trading and how people make or lose money in the trading process. Quite simply, futures trading is the buying and selling of futures contracts or options on futures contracts. (You’ll learn about options on futures in Chapter 9.) If you buy a futures contract at one price and sell it at a higher price, you make money. If you sell at a lower price than you paid when you went long, you lose money. In trading futures and options on futures you can buy and sell in whatever order you want. You can buy, then sell or sell, then buy. Whichever way you choose, the selling price should be higher than the buying price if you want to make a profit. The rule is to buy low, sell high.