“Futures are speculative, leveraged instruments and aggressive traders can lose big, but these derivatives also can be prudent ways to diversify portfolios and hedge against losses in volatile markets.” – Market Watch, How to Buy Futures, Getting Started
I read “Investing for Dummies” so I can help you. Let’s take this one step at a time.
Futures is a contract obligating the buyer to purchase a commodity at a specific date in the future aka Future Delivery of agricultural products, originally regulated by the Commodity Exchange Act of 1936 and was restricted to producers and end users. In 2000, Bill Clinton signed a law that changed these dealings to be supervised by federal regulators under general “safety and soundness”, making the trades “Over-The-Counter” or another table in the casino.
Speculation is the practice of engaging in risky financial transactions in an attempt to profit from fluctuations in the market value of a tradable good. We take risks everyday the question is; How much money can you afford to lose?
Leverage in this case is the use of borrowed money to increase the potential return of an investment. So you borrow from Peter to up the stakes at the roulette wheel, your number does not win, you lose the money and still owe Peter. Unless, of course, Peters friend Paul has a way to shift the debt to the tax payers.
Commodity futures are derivatives, derived from the value of something that may or may not be related. A derivative is a contract that derives its value from the performance of an underlying entity. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as collateralized debt obligations, credit default swaps, and mortgage-backed securities. This is where it REALLY gets complicated. Fuel prices have an affect on crops, that’s understandable. But did you know that you that the weather is considered an asset, even though it has no direct value, that the price of beans is derived from? Am I the only one who finds bad debt swapping a cause for wheat price increase an absurdity?
Futures can be a hedge against losses in volatile markets. Hedging is making an investment in order to reduce the risk of losing money in one security, by taking the opposite position in a related security. If you bet on every horse in the race, you are guaranteed to win.
Volatile markets have unpredictable and vigorous changes in price thus profit/loss margin. Seriously, is there such a thing as an in-volatile market? Our whole national and global financial situation qualifies as highly volatile to many.
My advice is to hedge your risky investments in the stock market, without leveraged instruments, in a diverse portfolio of commodities that you take possession of immediately for use in the future just in case unforeseen derivatives threaten volatile markets.