The commodity futures market is one of those economic institutions that most Americans manage to ignore successfully.
The price of "September wheat" on the Chicago Board of Trade is too far removed from the next loaf of Wonder bread for most consumers to worry about. Elected officials generally can't tell a pork belly from a pork barrel. Even sophisticated investors are nervous about a market so volatile that you can double your money in less than a week -- or be wiped out completely overnight.
But it's hard to ignore the commodity market when the action becomes so frantic -- as it has in gold and silver -- that it breaks onto the front page. When the government orders the grain markets closed in the wake of President Carter's embargo on sales to the Soviet Union, readers start asking why and what it means.
This, the latest in The Washington Post's series of questions and answers about economic and business issues, is meant to be a primer on the futures market and how it works. Tomorrow we'll look a little deeper into the market and take a crack at some of the questions raised by recent actions.
QUESTION: What is the commodity futures market and how does it work?
ANSWER: America's commodity futures market is a network of independent marketplaces in Chicago, New York, Kansas City and Minneapolis where the prices of many basic commodities are determined.
Corn and wheat, gold and silver, potatoes, pork bellies, plywood, coffee and cocoa, foreign currencies and home mortgages all provide action for commodity investors.
The most important thing to know about the commodity market is that it doesn't deal in bushels of corn or bags of coffee. The only thing that changes hands are pieces of paper called futures contracts.
Q: What's a future's contract?
A: It's a promise to buy or sell a specified amount of a commodity at an agreed-upon price at some future date. Consider corn. A corn futures contract on the Chicago Board of Trade is for 5,000 bushels, roughly a boxcar load. Corn contracts now are available for the months of March, May, July, September and December this year and for March of 1981.
The prices shown on the commodity market tables reflect what the markets predict corn will be worth on those dates. Last Friday, corn closing prices ranged from about $2.75 for delivery this March up to $3.215 for March of 1981. The prices go up for each succeeding month, indicating that corn will be more costly next year than it is now. Those prices are determined in a daily auction in the Board of Trade's corn pit, but more about that later.
Q: What's the purpose of the futures market.
A: Economic theorists say there are two principal functions of futures markets -- hedging and price discovery.
Price discovery is easy to understand. The futures market tells you what a commodity will be worth in the future. A builder who is planning to put up a batch of houses next fall can check the September futures prices and see how much he's likely to have to pay for plywood and lumber.
Hedging is more complicated, but basically it means protecting against unexpected changes in price.
Take the case of a grain elevator owner in Kansas. The elevator owner buys wheat from farmers at harvest time and sells it to flour millers over the next several months. To protect against falling prices, the elevator owner sells wheat futures contracts on the Kansas City Board of Trade.
The price is locked in when the elevator owner sells the futures contracts. If wheat prices fall later, the elevator owner is protected. On the other hand, if prices to up, the elevator owner may miss a chance to make an unexpected profit. But the elevator owner is willing to trade that opportunity to make money for the assurance that he or she will not lose.
Q: Okay, so far, but who uses the futures market?
A: There are basically two kinds of players in the commodity market -- hedgers and speculators. Hedgers are trying to protect themselves from price changes and speculators are trying to make money from price changes.
The term "grain speculator" sounds a little pejorative, but it shouldn't. The markets wouldn't work without the speculators. It's the speculators who take the risk that the hedgers are trying to avoid.
When the Kansas elevator owner sells wheat futures to hedge against a price decline, the person who buys those futures contracts will be a speculator who's betting prices will not go down. If the price of wheat rises above what the speculator paid for the elevator owner's futures contracts, the speculator will make money. If the price falls, it's the speculator who loses.
Q: You mean you can make money in futures regardless of whether prices go up or down?
A: That's right, commodity investors either can buy or sell futures contracts depending on whether they expect prices to go up or down. You don't have to own any corn or any futures contract to sell corn futures. It's all a matter of paper promises with price tags attached to them.
Those who buy futures contracts are known in the trade as "longs." The "longs" are counting on prices to increase, so the contract they buy can be sold later at a profit.
Sellers are known in the futures markets as "shorts" and are betting that prices will fall. The "short" in effect sells something he doesn't own, in hope that the price will go down before the delivery date and he can buy it back for less than he sold it. If the price goes up instead, the "short" must pay the difference between the price he got for the contract and the new price.
Selling something you don't own is a difficult idea for many investors to accept. But it's an essential technique in the futures market.
It's important to remember that there must be one "long" and one "short" involved in every futures market transaction. The "long" thinks prices will go up; the "short," down. Only one of them can be right, and only one can make money.
That's because the futures market is what economists call "a zero-sum game" -- that means for every winner there must be a loser.
Q: How much does it cost to buy a futures contract?
A: That depends on the commodity, but most futures investments are highly leveraged. Usually a speculator needs to put up less than 10 percent of the market price of the contract. To discourage speculation in silver, however, the down payment has been boosted recently to almost 50 percent of the value of the contract.
That initial payment is called the "margin," and it enables the speculator to multiply the profit or loss on a deal dramatically.
With corn at $2.70 a bushel, a 5,000 bushel-contract is worth about $13,500, and a speculator would need $1,000 to buy a contract.
Each time the price of corn goes up a penny, the value of the contract increases by $50. To control wild swings in prices, the commodity exchanges set daily limits on how much prices can move. The corn limit is 10 cents a bushel a day -- $500 on a 5,000-bushel contract.
If corn goes "up the limit" for three days, the speculator will make a $1,500 profit on a $1,000 investment -- a 150 percent profit in three days.
On the other hand, if prices turn down, the speculator can lose the entire investment -- and more -- just as quickly. If corn drops 50 cents a bushel, the speculator who bought a futures contract is liable for the entire $2,500 loss, not just the $1,000 margin payment.
When prices start to slide, the broker deducts the amount of the daily loss from the customer's margin payment. When the losses start to make a major dent in the margin -- the customer gets a "margin call" from the broker. The call means the customer either must put up more money to make up for the losses, or the contract will be sold immediately. The customer who thinks prices only are dipping temporarily can't wait for them to come back up again; it's either meet the margin call or get out.