Welcome back to our journey through the world of futures markets! So far, we’ve explored two fundamental players, the hedger and the speculator. These two have unique roles and motivations in the market, yet there’s so much more to uncover. As we progress, we’ll dive deeper into each participant, concept, and variable that shapes futures trading.
Today, we will take a closer look at what it means to establish a position in a futures market and how it differs significantly from a position in the physical commodities market. So, let’s dive in!
1. Physical vs. Futures Market: A Fundamental Difference
In a physical market, buying a commodity requires you to pay 100% of its value upfront and find a place to store it. If you buy aluminium, for instance, you have to consider not only storage costs but the total outlay of funds.
On the other hand, in the futures market, you’re essentially buying for a future date, which means you don’t need to own the physical asset or worry about storage. Instead, you secure your position by paying a margin, a fraction of the asset’s full value.
2. The Role of the Broker
Before trading in the futures market, you need a broker, a financial entity that provides access to the market and facilitates transactions on your behalf. Once you’ve opened an account, you can place an order to buy or sell futures for a set date.
By working with a broker, both hedgers (those seeking to reduce risk) and speculators (those seeking profit from price movements) gain entry into this market, allowing them to take positions without handling physical commodities.
3. The Power of a Fixed Price in the Futures Market
When you establish a futures position, the price for that future date becomes fixed at the time of purchase. This locking-in of prices can benefit both hedgers and speculators:
Hedgers, such as manufacturers, avoid potential price hikes by securing a steady supply cost.
Speculators, meanwhile, look to profit from expected price changes.
4. The Importance of Margins: Initial vs. Variation
Initial Margin: To establish a futures position, you pay an initial margin, which is a small percentage of the asset’s value (approximately 7% on the London Metal Exchange).
Variation Margin: As market prices fluctuate, there may be a need for additional funds, known as the variation margin. For example, if you bought aluminium futures at $2,700 per tonne and the price drops by $10 per tonne, you’d need to add $10 per tonne to your margin account.
What’s Next?
As we move forward, we will explore each concept in greater detail, including the intricacies of margins, price movement implications, and the role of each participant in various metal exchanges, such as the London Metal Exchange (LME). Our goal is to master the dynamics of the futures market, uncovering how it empowers market participants to hedge risk, speculate, and achieve their financial objectives.
Stay tuned as we continue this journey to unravel the complexities of futures trading and bring clarity to the mechanisms that drive these markets forward!