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How is it even possible to sell a future before buying it at first????????? I just don’t get it. I’ve seen the OT lecture. But Kaplan f9 book has confused me.
It is the same with most financial instruments.
Let me give you a very simple example.
Suppose you want to buy 100kg of flour. The current price is $1 per kg, but I think the price is going to fall in the next few days.
I offer to sell you 100kg at $1 a kg and deliver it to you in one week. In one weeks time I buy the flour and deliver it to you. If I was correct and the price of flour has fallen, then I buy it cheap but sell it to you for more and make a profit!
I took a risk – I could have been wrong and the price may have gone up, in which case I would have lost money.
You (the buyer) came to me because you preferred to have a fixed price rather than be uncertain as to how much you would have to pay in a week.Its the same principle with futures – you can buy now and sell later (in which case if the price goes up you make a profit, if the price goes down you make a loss). Or, you can sell now and buy later (in which case if the price goes up you make a loss, if the price goes down you make a profit).
The one thing is that you have to complete the deal (i.e. if you sell now, you have to buy at some stage to complete the deal).
I understand the concept, but how can I sell futures in the first place before buying them??????????
A future is just a promise…..a promise with a contractual obligation.
As in the example above, you want 100kg of flour next week and I agree to sell it to you at $100 per kg. I don’t own any flour but I promise to sell it to you in the future. When next week comes and the price falls to $95 per kg, I buy the flour from someone else at $95 per kg and sell it to you for $100 per kg, thus pocketing $5 for every kg.
If the price rises to $105 per kg instead, then i have tyo buy it for $105 from someone and sell it to you for $100, thus losing $5 on every kilogram. It’s all a gamble.
Remember you don’t have to show ownership when you sell a future, you just have to make a promise to deliver. (that is the brief understanding, of course you are going to realise in your studies that futures are actually more regulated than that and what has been described is the forward market, but the two work on pretty much the same principle).
I’ll give you another example….
Let’s say the latest Android phone is coming out next month and the price is uncertain. I promise to get it for you at $700 if you pay for it now. Your choice is to risk waiting till next month to find out what the phone will really be retailing for (i.e. assume the risk) or fix a price with me and hence pass the risk on to me. (Note, the phone isn’t out yet, so I don’t have it in hand.)
When the phone comes out next month, I have to buy it and deliver it to you……here are the outcomes:
1. If i can buy the phone cheaper than $700 then I make a profit.
2. If I buy the phone for more than $700, I make a lossSo in this case, I would have sold you a phone, before I bought it…. 😀
I was thinking like this. For example I’m a supplier based in UK and I’m about to get a payment in US $’s. I’m also expecting US$ to weaken in value and so a lower receipt when I convert it to GBP’s. So I buy US$ futures from a futures exchange for the amount of receipts I’m supposed to receive in US$’s. If $’s depreciate, I can sell the futures for a higher amount of $’s and cash a profit. I can use this profit to cover the loss from the receipt I am expecting from my customer. If $’s appreciate, I’ll suffer a loss when I sell my futures but achieve a gain from the receipts in $’s when I convert it into GBP’s. Is this how it works?
Yes, thats the idea of it 🙂
The profit or loss on the futures cancels out the amount lost or gained on the transaction.
Thank you my dear sir. You are the king of all lecturers. I’ve never met anyone like you before..
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