Are buying and selling futures based on objective data?

Question

I was thinking the other day that buying or selling futures is like gambling. It's based on no objective data and once you start pouring your money into it you can lose a lot...

Are buying and selling futures based on objective data?

Answer 1

If you're simply a futures speculator, then yes, it does seem like gambling.

If you're a farmer producing a few thousand bushels of wheat, futures can be a mechanism for you to hedge against certain kinds of market risk. Same if you're running a heating oil company, etc.

I just read somewhere that the bad spring weather in South Dakota has prevented farmers from getting corn planted -- nothing is in the ground yet. This is "objective data" from which you might infer that this year's corn harvest could be late and/or smaller than normal. So maybe if you're a buyer for General Mills, you use corn futures to control your costs. In this case you'd have some idea based on experience what to expect for the price of corn, what your production line requires for input, how much you can charge for finished product, etc. These all factor in to the price you'd be willing to pay for corn futures.

Answer 2

I own a gold mine and my cost of producing an ounce of gold is $600. Less than that, I lose money, anything over is profit. Today, at $1500, I sell futures to match my production for the next 2 years. I'm happy to lock in the profit. If gold goes to $3000, well, too bad, but if it drops to $500, I can still sell it for the $1500 as I mine it. I suppose I could also close out the contracts at a profit and still shut the mines down, but the point is illustrated.

Answer 3

If you hold a future plus enough cash collateral it is economically equivalent to owning the underlying asset or shorting the underlying asset. In general financial assets such as stock indices have a positive expected return - that's the main difference between investing and gambling. There's nothing that special about futures, they are just another contractual form of asset ownership.

Well, one difference is that regulations or brokerages allow individual investors more leverage with options and futures than with straight borrowing. But this is more a regulatory issue than a conceptual issue with the securities themselves. In theory regulators or brokers could require you to hold enough collateral to make a future equivalent to buying the underlying.

Answer 4

Let's ask another question: Why do you buy X at price $Y?

Here are some answers:

• You expect to get at least $Y worth of use out of X. This applies to a washing machine, a car, a dog, or a computer.
• You expect to be able to sell it for more than $Y plus expenses at some point in the future. This could be a futures contract, gold, a round lot of GOOG, yen, whatever.

Now, another question: Are you guaranteed to get at least $Y worth of value when you buy X?

Of course not! A lot of things can happen. Your car can be a lemon. Your pedigreed Dachshund can get run over by a snowblower. Or, the prices of the underlying commodity or security can go against your futures contract.

You can raise your chances of getting appropriate value out of X by doing your homework and hedging your risk. The more homework you do, the less of a gamble you're taking.