It might help to look at who the market participants in an example market like Corn. 1) Commercial Producers. These guys grow the Corn. They have actual physical corn either in storage or in the ground that they want to hedge against adverse price movements. In other words, if it costs them $1/bushel to grow corn, and they can sell a futures contract in December against their crop at $3/bushel, that's not a bad deal for them. They are *guaranteed* that their corn will sell at $3 in 7 months when it finally comes out of the ground. 2) Commercial Consumers. These guys need corn. They may produce ethanol, animal feed, Green Giant Nibblets, export to China, or a million other things. They want to be hedged against the price skyrocketing and them losing whatever profit margins they have. If China is willing to buy in December for $4/bushel, and they can buy a December futures contract for $3/bushel, that's a guaranteed profit. The consumer does not need to worry about corn going to $8/bushel and him losing money on the deal. He also will not profit additionally if the price goes down to $2/bushel, so he needs to carefully decide when to buy. 3) Speculators. These guys (you and me, most likely) have very little interest in owning any physical corn, but want to place bets on where the price of corn will go. If I buy a December contract at $3, I'm expecting a price rally for some reason, but someone sold it to me. It could be a commercial looking to hedge his crop. It could be a speculator betting the price will go down. The former is really an uninterested party--he doesn't care if the price goes up to $8/bushel, he's just locking in a reasonable profit for himself. The latter is making a bet I'm wrong. This dichotomy is what makes commodities so interesting. As December rolls around, I'm going to be interested in selling my futures contract. I don't want to own corn, and any price movement I would get has already happened. There are an exact equivalent number of shorts out there. Some want to dump their short because they are a speculator, some are happy to deliver on their short because they are a commercial producer. Spot will converge on futures because it's a simple arbitrage. You buy the futures contract and sell it on the spot market the next day when you take delivery. Any difference in price is pure (and free) profit. The catch is this: What happens when someone buys up all of the crop on the spot market AND buys futures contracts? As expiration rolls around, the people who are short will need to also buy to get out. Who is selling? It's not the guy who owns all the long positions. It's not the commercials because they've already sold all their crop. This is called "cornering the market", and there are now tons of controls in place to keep this from happening, but it has definitely happened in the past. In any case, your understanding of equities seems a little off too. Market Makers do not have a supply of stock sitting in their pocket and they "decide" what the price should be. The market at large has *WAAAY* more money then any Market Maker does. The MM does not set price at all--he just tries to scalp the middle.
Can you please elaborate on what you said "You buy the futures contract and sell it on the spot market the next day when you take delivery. Any difference in price is pure (and free) profit." How do you actually buy the futures contract and sell it on the spot market?
You would buy the futures contract, take delivery of the corn, drive it to the nearest grain silo, and drop it off at the spot price. If you can do this whole thing profitably, any difference between spot and futures (taking into account delivery and storage) is free money. (More realistically, you'd negotiate with the producer to drive it to the grain silo of your choice. He's got to ship it somewhere anyway in order to deliver, so let him take care of the logistics) Taking delivery is MUCH easier with crude oil, gasoline, soy meal, soy oil, metals, and I'm sure some others. (Some of those markets simply give you a receipt that you now own whatever the commodity is and start sending you a monthly bill for storage). Taking delivery is MUCH harder with sugar #11, cocoa, coffee, and some others.
Thanks for that explaination.... but can you give me an example of using ES (S&P futures)? how would you buy ES and then sell that in cash (SPX)?
Holy frickin' Chryst... Futures are the most simple concept going. How come ETers can't get it? (Please, nobody introduce Options... ET'll have a mental implosion!)
The most simplistic (but unrealistic) way to do this is to: 1) Buy ES 2) Sell stock in all 500 members of the S&P 500 index in the proper ratios. Other (more realistic) alternatives: 1) Buy June ES, sell a September ES contract 2) Buy ES, sell SPY 3) Buy ES, sell full sized S&P futures 4) Buy ES, sell SPX option deltas 5) Buy ES, sell anything highly correlated (OEX options, OEF, to a lesser extend EMD, NQ, YM) I saw part of your post before you edited it. The *farmers* do not decide how many futures contracts are on the market, it is the market participants on aggregate. If you've ever bet on the outcome of a sporting event, you know it's simply a contract between you and the other side. There is no limited supply of contracts. When the sporting event is over, you settle up and all the contracts go away.
z32000, congratulations on taking responsibility for getting answers to your questions. FullyArticulate, nice explanations. Wish you were around in the days of my yute. Osorico