Episode Transcript
[00:00:07] Speaker A: Hi, and welcome to Futures Discovery at John Lothian News. I'm your host, Cortez Draper, and like you, I'm no expert. But on this program, we'll embark on the fascinating world of futures and learn from top professionals in the field. In this episode, we will discuss what a futures contract is and how people and professionals use them in the real world to make money. In order to understand futures contracts, we must first understand futures. A futures is a type of derivative. I know this can sound complex, but don't let this word intimidate you. A derivative is a financial instrument that has its value determined by the price of something else. For example, if this pencil is worth $2 in today's market, a derivative on this pencil would derive its value from that price. As the price of the pencil changes, so does the value of the derivative. A futures contract is a standardized financial agreement to buy or sell an asset, commodities, stocks, currencies, et cetera, at a predetermined price on a specific date in the future. These contracts are traded on futures exchanges. Futures contracts require margin deposits to cover risk in the market movement, and traders are required to post additional capital, I. E. Make a margin call to maintain their futures positions should the market move against them. Unfortunately for our example, a pencil is not traded on an exchange. But in later episodes, we will discuss assets and commodities that are traded as futures. But hypothetically, for our example, I could use a futures contract to buy or go long this pencil at a specified price and date in the future. Let's say I want to buy this pencil for today's price of $2 exactly one year from now. I could use the futures contract. To do so. I would be considered long one pencil. Futures Contract if we want to execute this futures contract, there are some important terms we should know before doing so. The underlying asset. The underlying asset is the physical commodity or other financial instrument that the contract encompasses. Futures contracts detail the date, quantity, quality, and place and manner of delivery of the underlying asset. In our case, the underlying asset would be one pencil. Margin call. A margin call demands additional funds be deposited into a margin account to cover potential losses. Failure to meet margin call may result in a broker liquidating a position at a loss. Unlimited losses. Someone who sells short futures contracts is exposed to unlimited losses. There has even been recent cases of traders who bought over long oil futures who saw prices trade below zero as contracts reach their last trading day. So losses on long positions can exceed the full contract value. Spot price the spot price is the market price for immediate delivery of the underlying asset. In our case, $2 last day trading, the last day on which you can trade a futures contract.
First notice day. The first day the shorts may make delivery.
Expiration date the expiration date is the time at which contracts settle if it is cash settled. Unlike some financial markets, derivative markets like futures give you the ability to short sell. Short selling and futures Trading is a strategy where a trader sells futures contracts they do not currently own with the expectation that the price of the contract will decline in the future. The trader aims to profit from the price difference between the contract selling price and the lower price. They can buy it back for covering their short position later on. To better understand short selling, let's use our pencil example again. Let's say I'm a pencil manufacturer and I'm concerned about pencil prices dropping next school year. I could sell short August 2024 Big Mechanical pencil futures contracts to lock in my price for next fall's pencils production. Most likely a speculator would buy those contracts from me, but it could also be someone who needs pencils, like a school or business who's afraid prices are going to rise. That is what makes markets differing. Opinions about future direction of prices let's say I sold my August 2024 Big mechanical futures contracts at $2 and at some point in the future when prices declined to $1 and I didn't think they were going to go much lower or I had sales to deliver to clients, I could buy back my futures contracts. If I sold at $2 and bought at $1, I would have protected myself from a decline of $1. When I sell actual pencils in August of 2024 at the price of $1, I will have actually realized $2 per pencil because of my timely hedge. It's important to note that this entire process usually takes place behind a computer screen at a much faster rate. In the futures market, we can also take a long position, which means we are the buyer in the market. If we were a school that was concerned about the price of pencils rising, I could hedge that risk by buying an August 2024 Big mechanical pencil contract. Or if I were a speculator and I noticed there was a large increase in number of children registering for school, I might want to go long pencil futures in order to profit from the rise in pencil future prices. As demand increases for pencils going into the fall school season, the payoff, or long or short, is the value of the position at the point at which we exit prior to the final trading day or expiration of the futures contract. Each futures contract that is listed on the exchange has a month that goes into delivery or is cash settled. Each contract then is referred to by its month. For example, the August 2024 Big Mechanical pencil mentioned earlier. If August 2024 BitMechanical pencil contract is physically delivered, will deal with cash settled another day, then there will be a first notice day for the contract prior to the final trading day. During this delivery period, and only during this delivery period, on or after the first notice day, may the shorts deliver to the longs. That means if I had bought an August 2024 Vic Mechanical Pencil futures and held it to its first notice day, a short that had made a delivery could be assigned to me, depending on how old my long position was. If I was holding the oldest long position, I would have received the first delivered short contract the next day. I could sell in August 2024 Big Mechanical Futures contract and then retender the delivery, exiting my position in pencils once and for all. However, the best solution is always to exit your position prior to the first notice day, the first day that shorts can deliver so that you are not involved in the delivery process. Liquidity or the number of buyers and sellers participating in a specific Futures contract month tends to dry up as delivery approaches because many traders are smart enough to know that they do not want to deal with physical delivery. Delivery is for the legitimate hedgers and users of the underlying product upon which the derivative futures contract is based. Industry professionals use futures contracts for a multitude of reasons, risk management and hedging speculation, reduced transaction costs and regulatory arbitrage.
Let's now talk to Joe Ferreiro, President of Myx Futures and the leading professional in futures markets, to help us understand better how we can use these contracts to make money and hedge risk.
[00:08:08] Speaker B: Thrilled to have Joel Ferreiro, the President of MYX Futures, here with us today. With the wealth of experience in the financial industry, Joe has risen to a leadership position that ultimately affects the future of futures trading. He's navigated through various roles throughout his career, landing as the pivotal force behind MyX Futures. We're here today to delve into Joe's insights on futures contracts and markets, and to learn more about MYX's pivotal role in shaping this dynamic landscape. You're now the President of MyX, and MyX is establishing itself as a prominent player in the future space. Could you provide an overview of MyX's role and contributions to the arena?
[00:08:47] Speaker C: MYX is just about a little over ten years old, and the core business for MYX is US options. That was the launch product back in 2012. Today, we currently operate three US options exchanges and also a cash equities exchange. We're also launching a fourth US options market, which is going to have a state of the art trading floor in Miami, Florida. Many employees are anxious to start making the trip down there.
So having both us options and cash equities, we were really missing that third leg of the stool, if you will, which was futures. And so we made the decision to get into the futures business so that we could be a multi asset exchange operator and cover all the major asset classes.
And we did that through the acquisition of the Minneapolis Grain Exchange back in December of 2020. And MJX, it's actually one of the oldest futures exchanges dating back to 1881.
So it's a really interesting business. It's an exchange, so it's a designated contract market, or DCM, and it's also a clearinghouse, a derivatives clearing organization, or DCO.
So it's a very interesting asset and it's going to be the basis for us building out the Futures business under my act. And we also just recently acquired another asset in this space, and that's called Ledger X.
Ledger X operates also as a DCM, also as a DCO, and also as a set. So a swap execution facility. So it has a broad range of products that it can list and clear on its market. So now we're in the process of taking those individual assets and using them to build out our futures business.
We're going to look to leverage a lot of the technology that we've built for our original options market and our cash equities market, and a lot of the relationships that we have have built as part of that to deliver a very similar experience in the futures and.
[00:11:23] Speaker B: Futures options business for those new to the concept. Could you explain what a future contracts are and why they exist and how they make futures markets operate?
[00:11:35] Speaker C: Very simply, a futures contract is just an agreement between a buyer and a seller to lock in a price today for some underlying asset that gets delivered in the future.
That's it at its very basic premise. Now there's various different flavors and so forth of types of futures contracts, including what there could be a futures contract on. So what's the underlying asset of the futures contract? Traditionally, they were agricultural, they were commodities, right? They were hard red spring wheat, they're corn, soybeans.
But over the last couple of decades, the underlying assets for futures contracts has significantly expanded to include financial futures, currency, futures rate futures, and it goes on and on. So there are a tremendous amount of underlying assets now for futures contracts. One of the key features, though, of futures is that they're standardized. That means you can buy it and sell it, and it's subject to the same terms whether you're a buyer or a seller in the market. That's very important because it allows for increased liquidity in the product. They're also regulated heavily by the Commodity Futures Trading Commission or the CFTC. Futures can get very sophisticated and they're used for very sophisticated purposes as well. But at its very basic, it's really just an agreement to deliver an asset in the future at a predetermined price.
[00:13:25] Speaker B: One of the significant parts about futures contracts is hedging. So, can you elaborate on how businesses and investors can use futures contracts to hedge risk?
[00:13:34] Speaker C: In order for a market to work properly and function properly and efficiently, it has to have the right mix of market participants. You can't just have buyers, you can't just have sellers, you can't just have hedgers, and you can't just have speculators. You need them all in order for the market to function efficiently.
So there's two main, I would say, groups of market participants in the futures markets, and the one you just mentioned is hedgers.
These are generally commercial users connected to the underlying asset, that have exposure to the underlying asset and are looking to hedge that exposure or to provide some certainty around the price of that asset in the future. So you think about it, we have, like I mentioned on MJX, we trade hard Red Spring wheat.
So if you think about the parties involved in the wheat market, One of the biggest is the farmers, right? The farmers are planting their crop and are planning to sell it when they harvest it at some point in the future in order to eliminate and what can happen to the price of wheat during the time between when they start planting versus when they harvest and sell. The price could fluctuate quite a bit.
So the farmer is able to hedge that price exposure by selling futures contracts now, that would be for the delivery of the wheat at some point in the future at a predetermined price now. So the farmer is able to eliminate that exposure to the price fluctuation by selling those contracts.
By selling those futures contracts.
It's the same, but the inverse for the buyer of that wheat.
They need to buy that wheat in the future. And one way to eliminate the potential volatility of the price during that time leading up to when they need to take delivery of the wheat is through buying futures contracts. So they're able to lock in the price of the wheat now and know the price that they're going to have to pay when it gets delivered, a very important part of the market. And it allows these users of the product to be able to price certainty around their commercial use of the product.
[00:16:35] Speaker B: And so we talked about hedging. And let's go on the flip side. Now, one of the other big market participants also involves speculation.
Can you explain what speculation is? A little bit. And then what drives individuals and entities to engage in speculating when trading future markets? And what role do speculators play in the market?
[00:16:56] Speaker C: Speculators are another critical, important piece of the market and market participants.
Speculators don't have a similar reason to try to lock in a price like a hedger does. A speculator is what I refer to as a positional type trader that's looking for exposurely asset. So it can be an individual, it can be a firm. There's all different types of speculators. There's proprietary trading firms and portfolio managers, hedge funds, market makers.
But what they do is they accept risk with the goal of trying to make a profit. And speculators run all different types of trading strategies. Speculators look at historical prices in an asset. If you look at a futures contract historical chart in certain products, there's patterns that one can draw, and there could be trading strategies developed around that to try to profit from those patterns. Historically, there's also macro forward looking speculators that are predicting that there'll be some type of an event or some other occurrence that's going to happen in the future.
And they're speculating that that's going to cause the price of the underlying asset to move in one direction. And they're looking to capture the profit associated with that. Speculators, because they have very different strategies, are very important to helping a market form price discovery and create an efficient market.
[00:18:53] Speaker B: Would it be okay to think about it as people who are willing to assume risk now to make reward or profit gains within the market? So you have participants like you talked and you said very well, objectively, looking to hedge their risk and get out of the volatility, while speculators were probably looking to profit off volatility and assume the risk at different points in the market.
[00:19:16] Speaker C: That's exactly right Cortez. And that's what makes for a functioning market, and that's what you'll see. Some of the most successful futures contracts historically have been those that have a very healthy mix of speculators and a very healthy mix of commercial end users and hedgers.
[00:19:41] Speaker B: How do futures contracts assist in price discovery and bringing efficient to market operations everywhere.
[00:19:47] Speaker C: Markets serve really to help form price discovery. And so futures contracts assist in that, because if you can have a centralized market, and again, have all the right market participants involved, buyers, sellers, hedgers, speculators, that's what makes for a most efficient market price and determination.
When you have kind of bespoke liquidity, that's what leads to bad price discovery, right? You want to have one centralized marketplace where all the trading is taking place so that there can be the most efficient price discovery at that spot. Right? And you think about historically, like futures contracts before the age of the Internet and before us being able to get real time prices available just at any point in time, it would take days for prices to travel or for information to travel to people that are participants in the market. And so having this centralized marketplace where we can get real time information, creates virtually instantaneous price discovery for people that have exposure to the markets. Some markets, futures markets trade close to 24 hours a day, five days a week, and eventually we'll get to it really just allows market participants to manage their exposure around the clock. It's allowing for this real time transfer of risk, management of risk basically around the clock to be able to allow all these global market participants to be connected to one centralized market.
[00:21:57] Speaker B: As with any financial instruments, there are downsides to consider when interacting with these markets. What are some of the potential risk and downsides associated with trading future contracts?
[00:22:08] Speaker C: A lot of those risks are the same types of risks that you would see in any type of investment, whether it's in stocks, options, real estate.
But with futures just like those others, the main risk is loss of your investment. Futures involve leverage, right? That's one thing that we didn't really touch on just yet. So, typically, when you buy a futures contract, you're not having to post for the full value of the futures contract. You post margin, right? And a margin is a portion of the total value of the contract. So since futures contracts involve leverage through the use of margin, that sort of amplifies the level of risk associated with the product.
And so you have typical suitability type questions that you have for any product.
We have a very good regulatory model in the US that looks to make sure that these types of products are suitable for the people that are trading them. So if you've ever gone to and opened up your retail futures trading account, you have to answer a bunch of questions to make sure that's so that the broker knows that these types of products are suitable for you.
[00:23:37] Speaker B: We graciously appreciate your time and your insights, and we'll be looking out for my futures in the future and the concert that you guys have to the futures markets. Thank you, Joe.
