Tuesday, October 09, 2007

Futures a Ticking Time Bomb

Suppose you own a gold mine and your cost of production is $500 per ounce and you know you can output 4,000 ounces a month. Let’s say the spot price for gold is $700 per troy oz. As a miner owner, you would want to lock in your price for product mined for delivery in 30 days. You would sell 40 gold contracts which would be a promise to deliver to the buyer 4,000 oz of gold 30 days in the future. In this example the Gold future is being used as an economic tool that guarantees the success of the mine even if the price of gold drops through the floor. The mine owner has locked in a price and taken the risk out of the business.

Suppose you don’t have a gold mine and you want to play the game. No problem. There are two exchanges the Comex and the CBOT. The margin requirement for Gold on the Comex is $2,700 per contract and maintenance is at $2,000 (FYI don’t use the CBOT, they screwed Bunker Hunt when he cornered the silver market in the 80’s by changing the rules).

As a futures trader, $2,700 controls 1 gold future 100 oz of gold worth $70,000. Notice that the buyer and the seller of futures don’t have to be connected to the product in the contract. Usually before the contract is due for delivery, it is closed out. If you went long and bought a contract you sell it and if you went short and sold one, you buy it back before expiration.

This is a zero sum game. For every winner there is a loser. Airlines are known to lock in their fuel prices with futures. So all we need it a buyer and a seller, we don’t even need product. This can be done with bonds, gasoline, wheat etc.

All we are discussing here are commodity futures, pretty basic stuff. Notice that they are created out of thin air. And no product has to change hands.

Take the S & P 500. Why buy all of the stocks and pay a commission? Go buy a future on it. Most futures probably only demand a 6% margin requirement. These are rather abstract financial instruments; there is nothing tangible about them. The margin on an S&P 500 full contract would be about $25,000 (depends on the broker) and it would control $781,000 dollars worth of stock. There is also the CME Mini S&P 500 futures contract, kind of a bike with training wheels for beginner day traders, which has a margin of $4,000. It’s 1/5th the size of the big one.

If the DJIA were to drop 2,000 points, which would be a drop of 240 points on the SP500 (forgive me for not calculating the loss) the naked sellers of the futures are toast. The margin maintenance call would be a real killer. Even if the market were to come back, you still have to meet the margin call. But if you read the boiler plate on your contract, you have already been sold out at an unimaginable loss without your permission. Gee Whiz can they do that??

I kind of remember reading that the crash of 1929 couldn’t have happened if the stock margin requirements had been set to more reasonable levels. (Yawn) believe that and I have another for you. The phrase "Parallels in history," comes to mind.

The other neat thing about futures is that they are tax free. But I didn’t say that did I? The government has no way of tracking them, so grab a future and have a good time. Be careful the end is near.


Debbie said...

My brain has exploded.

Anonymous said...

"Be careful, the end is near."

you have been saying that for a while now on this blog, the title gives the hint, can you please give a broad estimate? weeks, months, years?

People who thought the end was near after the 2000 dot.com bubble, have missed a 100% gain in the indexes alone.

My point is that, anyone can say that we will fall eventually, business cycles are part of the global economy but there is a lot of money to be made in the meanwhile.

The saying goes, "the markets can remain irrational a lot longer than you can remain solvent". Never more true than in the past 20 years, since the 87' crash.

What you think Jim, should we all just be bearish on the U.S. economy till the end of time?

Jim in San Marcos said...

Hi Anon 6:04

What’s going to happen isn’t printed out on something neat like a train schedule. What I was alluding to is the money that can be made in the futures market. You want to put a 100k in the stock market, even with the way things are going, it’s a pretty pathetic return for the risk taken.

When things get bad in the future, as I am suggesting, there is a very lucrative return on 5% 30 year bonds discounted 50% or more. Real estate rental will be a gold mine in 3 to 4 years when housing prices hit bottom. The trouble is, you need cash to play, and when the big day happens, most people will have no cash to take advantage of the sales.

I would suggest that there is no room to be bearish about any financial opportunity; the greed factor is what does most people in.

You mentioned the dot com bubble, I personally know two people that lost over half of their savings and had to post pone retirement.

We are at the same place and time again. That doesn’t mean that you can’t make a $1000 dollars a day on 1,000 shares of Google. But ask yourself two questions, does common sense even enter the equation? Does the rate of return for effort expended, merit the reward? For most people the answer is no. It’s money, money, money.

Last year there was no housing crisis as far as most people were concerned. Us bloggers were ahead of the papers by one whole year. Now nothing is selling, so should we be bearish on the economy? There is a good case for it.

If you are my age of 60, the concern is the preservation of what we have worked so hard for. If it takes a $1,000 to buy one bag of groceries, we will be stuck "Holding the bag."