How is money made trading futures ?

[KRDXB]

Hello all,

Attemting to get to grips with trading and I have found myself confused as to how money is made via a contractural futures agreement. The example which has confused me can be found in the following link:

http://www.investopedia.com/university/futures/futures2.asp

In short the example involves a farmer and a bread maker who agree on a futures contract stating that the bread maker will pruchase 5000 wheat bushels for $4/brushel from the farmer at a date in the future. A day after the the agreement the price of a wheat bushel increases to $5/brushel.

This is where I get confused. The article states: "On the day the change occurs, the farmer's account is debited $5,000 ($1 per bushel X 5,000 bushels) and the bread maker's account is credited by $5,000 ($1 per bushel X 5,000 bushels)."

What I dont understand is why cash is being debited and credited. The two parties have agreed on a commodity transaction at a certain price, for a future date, so in my mind the only way the bread maker will make a profit is if the price of wheat is $5/brushel on the date of contract closure and the bread maker decides to sell his wheat purcased for $4/brushel from the farmer, at $5/brushel on the commodity market.

How and why is money being debited/credited when a transation of cash/commodity hasnt even occured yet?

Thanks and I hope this wasnt a silly post.

 

[evertontrader]

As the reply above doesn't answer your question, here is a short explanation.

Future contracts are "marked to market" daily. This means any debits/credits required due to price changes for both sides of the contract are settled in both seller & buyer accounts, at the end of each day, so on the delivery date, the amount exchanged is not the specified price on the contract but the spot value. This happens for a few reasons, mainly to limit the exchanges/clearing house risk (they guarantee to honour your position to the other party) and to make it clear what the material loss/gain would be on the contract if either account was to offset the contract early.

Hope this helps.

 

[KRDXB]

As the reply above doesn't answer your question, here is a short explanation.

Future contracts are "marked to market" daily. This means any debits/credits required due to price changes for both sides of the contract are settled in both seller & buyer accounts, at the end of each day, so on the delivery date, the amount exchanged is not the specified price on the contract but the spot value. This happens for a few reasons, mainly to limit the exchanges/clearing house risk (they guarantee to honour your position to the other party) and to make it clear what the material loss/gain would be on the contract if either account was to offset the contract early.

Hope this helps.

Lol yeh, and thanks for the reply, I have a better understanding of the relevance of futures in relation to trading as a speculator rather then actually looking to purchase a commodity after contract closure.

 

[b0lty]

Following on from this, could someone explain how this works at a practical level when you're at your trading platform? How do you initiate a trade and what are you selecting from? Will I see a list of say, corn contracts available and I pick the one I like the sound of? Or am I just told 'buy or sell a futures contract at the current market price of xyz?'

Am I pairing off with someone else and one of us will win and one will lose? I read that you can close your agreement at any time so would that mean my position could close at any time if the opposite person in the contract decides to close it?

Or is it all automated and essentially I'm just picking a long or short position on a commodity that I can close at any time for a profit or loss?

All the examples online talk of entering a contract with someone else but they don't explain what this translates to at a practical level.

 

[TWI]

You are not trading with another person, you are trading with a clearing house of an exchange. Once you hold a future you can decide when to get out of it but best you exit before the start of the contract month you hold if it is deliverable, like corn, or you will end up with corn in a warehouse in the US or being asked to deliver same if short. Other than that you can buy or sell whenever you want. When you trade your broker will retain a margin which is required by the exchange to hold the position and also daily either debit or credit your account with the profit or loss your position has made. Very important to know how much you are risking in a trade. For example in corn you will make or lose $50/cent per contract, that can get expensive quickly if the market is moving 20c ($1000/lot). Also with futures you will see that there are various forward expiries. Right now in corn this is H(march) K(May), N(July), U(Sep), Z(Dec). These trade at different prices because corn is a seasonal product, it is harvested in the US in Sep/Nov and then stored in warehouses and silos. So generally the cheap month in a normal crop year is the Z contract and then subsequent contracts are priced at increasingly higher prices, this is referred to as a carry and allows for the cost of capital (used to buy the physical corn) and the storage costs. This will usually progress until the next Z contract where the prices will be lower or inverted to the preceding N and U. The forward curve is important when trading futures and understanding contango and backwardation is essential in commodity futures particularly. In my experience the majority of commodity props trade more spreads than outrights in a normal year.

 

[fxstrategist]

I think that the original question was about a contract between a farmer and a broker? He was not referring to an electronic exchange, hence the confusion of why are there accounts being credited and debited if no transaction has ocurred. Keep in mind that you can take delivery too of a futures contract.