In financial terms assets like grain, sugar, wheat and farm animals are all in the derivative market. You don’t actually go buy sugar, corn, wheat and farm animals when you invest in this, you buy futures contract. Think of it as a bet. You bet that the market price will go up higher or lower, in other words you’re playing against time. I will tell you the story of my friend Tom, a farmer, as an example to help you understand what derivatives are.
My friend Tom is a farmer who raises goats. He has ten goats and wants to sell them in the market one year from now. He knows he will have to spend $30 per goat to raise them. So his total investment will be $300. But he is worried about if a disease breaks out amongst his goats he won’t get much money for them when he decide to sell them one year from now. So to protect his business, Tom meets an investment broker and enters a business contract with him.
Let’s assume that you are the investor who has sent your broker to Tom. You think that a disease amongst your goats is not likely to occur. So you tell your broker to agree to pay Tom $100 per goat one year from now, regardless of the market price. What you have done now is to enter futures contract. Basically futures are contracts that obligate the buyer to buy an asset and the seller to sell an asset at a predetermined future date and price.
In this case the futures contract obligates Tom to sell his ten goats to you at $100 per cow and obligates you to buy them regardless of the market one year from now.
Tom will agree to this because this means that one year from now, regardless of what the market price is for goat, he will get a profit of $100 minus $30 that equals a return of investment (ROI) of $70 per goat. He has limited his risk and locked in in his profit.
In your case, if you were right about a disease not breaking out, you would gain a profit from your investment. One year from now, the price of the cows in the market may have increased to
$200 per goat. This means that you would buy his goats for $100 per goat and sell them in the open market for $200 per goat, making you a profit of $100 per goat. In other words $1000 profit in an investment of $1000.
But what if you are wrong and a disease breaks out. In this situation the market could drop to $20 per goat one year from now. This means that you have to pay Tom $100 per goat, since you are obligated by contract, and sell them at the market for $20 per goat. That gives you a loss of $80 per goat or a loss of $800 on a $1000 investment. So as you can see it’s a risk to take, no one knows what will happen one year from now.
So is there a way to reduce your risks as an investor? The answer is yes.
If, as an investor, you don’t want to take the risk of losing too much money you could simply have a Stop/Loss agreement with your broker. This means that as soon as it becomes clear that your loss will go beyond a certain level the broker will exit the futures contract and stop your losses from getting worse. If as an investor you instruct your broker to stop your losses at $50 per goat the minute the market price reaches $50, the broker will exit the contract by selling it to someone else and stop your losses at $50 per goat.