How do stock futures get a value assigned to them when we can’t even tell where a stock is going the next hour? And why/how do people buy them (financial product wise)?
In: Economics
No one can tell where a stock is going 1 millisecond from now, so why is buying a a future contract for some time that is not “immediate” so different? It’s not. To a degree, *every* stock purchase is a type of futures contract. Think about that and it may help. The *only* and I mean *only* reason you ever purchase a stock is because in the future you think the stock will be a higher value than your purchase value. The “future” in this case is any moment in time after your stock purchase.
Now the actual mechanics of each trade may be different between a market buy or a futures bet, but this is a good way to internalize it.
A futures contract is a hedge against the price volatility of a commodity. Say you’re a company that buys a lot of fuel in a year – such as an airline. Right now fuel is really cheap – say $35 per barrel – but you can’t buy all the fuel you think you need for the whole year right now; you might not have the cash on hand or a place to store that fuel even if you did. But because the price of oil may be volatile, you want to protect yourself in case it sharply rises later in the year. So, you make a deal with a fuel producer: You agree to buy the fuel you need for the end of the year at a set price – say $60 per barrel. The fuel producer agrees to this because it’s a guaranteed sale later in the year and believes the certainty of the sale outweighs the risk that fuel rises above $60, while you’re protected in case the price of fuel rises above $60 by the time you need to buy it. This is a futures contract.
Let’s say, however, that 2 months before the contracts of those futures comes due [and you’re obligated to buy a bunch of fuel at $60 per barrel] fuel looks like it’s still just as cheap as it was when in the beginning of the year. Your airline would like to take advantage of the cheap fuel costs, but it has these futures contracts on the books.
Enter a futures exchange. In order to get those contracts off the books your airline offers to sell those contracts to interested buyers. Say some investment company believes that the current cheap price of fuel is not reflective of true market conditions and expects the price of fuel to rise sharply – say to $80 per barrel – by the time those contracts are due. The investment company buys the airline’s futures contracts and expects to profit when the price of fuel increases.
How much your airline company is able to sell those futures for depends on what other futures contracts are available on the market and how certain investors believe the price of fuel will rise (or fall). If investors are certain fuel will cost $80 per barrel by the time the contracts come due your airline might even make a profit by selling off the contracts for more than the $60-per-barrel original price and make a profit. If on the other hand investors are less certain the price of fuel will rise your airline company may only get $50 or even less if they sell the contracts.
When you combine the collective buying and selling of lots of contracts by lots of companies and lots of investors, eventually the value will settle somewhere in the middle.
with stocks, you’re probably talking about options. You can buy or sell the option to buy or sell a stock at a given price until a given date. For example, if you have a stock that’s currently trading at $50, you could buy the option to sell it at $40 one month from now, so if it crashes to say $25, you don’t lose half your money, just the $10 per share plus the price of the option. Or you could sell the option to buy it at $60, if you sell this option for $1, then you make a dollar regardless of happens from the sale of the option, and you have to sell the stock for $60 if the person that bought the option exercises it. So you’re making money as long as the price of the stock doesn’t increase to more than $61, but missing out on some of the upside if it does go higher than that.
The pricing is determined by the price of the stock compared to the strike price of the option, the time until it expires, and the expected performance and volatility of the stock.
People also buy and sell options without owning the stock in question. For example, if you think a $50stock is going to go down a lot, you might buy the option to sell it at $40. So if the stock goes down to say 25, you can buy it for 25 and then sell it immediately for 40. Similarly, you can sell options to buy a stock you don’t own, but if the price goes up, you’re still on the hook to deliver it at the agreed price, so you can lose a whole lot of money this way, and your broker might not allow you do this.
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