This article originally ran in our 21st edition of our WTF is going on with the Economy?! newsletter about futures. Sign up here to get this future-acclaimed publication directly to your inbox.
If there’s a group of people who have more balls than a sports store, it’s futures investors.
After all, these folks are willing to give up the certainty of cash-in-hand today to risk it all for more in the future.
But what sets these market daredevils apart from other investors is these people claim that they know the future – from tomorrow, next month, and even next year.
Ballsy, right?
Here’s why they feel so confident.
The history of futures
Futures have long been a critical figure in the investment universe.
Futures are what we call “derivatives” in that they derive their value from a different or “underlying” asset.
These products had their origins in the industrial revolution and subsequent economic explosion starting in the late 19th century.
At the time, the world was getting much better at taking raw materials and turning them into refined products. Think wheat into bread, iron into steel, and sugar into rum, and you’ll get the idea.
Companies that create the finished goods need to give themselves some certainty about the raw material’s future price.
Without this knowledge, planning became too difficult, making it hard to set the stable prices that consumers need to feel confident about buying the product.
On the flip side, farmers and miners also wanted some price stability, since they too saw the benefit in knowing the future price of their raw products.
As a result, the futures market emerged, allowing both producers and manufacturers to set a future price for whatever commodity they chose.
Once the two parties agreed to a price – say 100 dollars for a barrel of oil for delivery three months from now – they were set.
The system took off, allowing producers and manufacturers to hedge their risks.
How investors use futures
With traders being the creative folk they are, they saw an opportunity to “bet” on future commodity prices by trading these contracts. Betting on futures works like this:
- A futures contract’s price comes from the current market price plus any other associated costs (like keeping a bunch of chickens for three months) over the contract (say one month from now).
- Between the time the contract opens and closes, traders can buy and sell it.
- An investor might think the price will be higher on the date the contract finishes. In that case, she will take delivery of the chickens at the contract price then sell them for a profit at the market one.
- The more people that think the market will improve in the future, the more demand there is for futures, raising their price accordingly.
- The opposite is also true. People can think the market will do poorly, lowering the price of futures contracts and letting people bet against the market like hedge funds sometimes do.
Suppose you’re a fan of the word speculation (we think it’s a bit overplayed for political gain these days). In that case, futures trading is about as close as you’ll get to the term’s purest definition.
How futures investors are predicting the future
Now, there are futures not only for the prices of commodities like gold, oil, tea, and pork bellies but also for major stock indices like the S&P 500, FTSE 100, and Stoxx 600, all of which investors bet on.
Unlike commodity markets, which track small slices of the economy, index futures look at broad stock market movements.
And while the stock market is partially disconnected from reality, it is still a reliable indicator of the whole economy.
For the fortune-telling investor, index futures are the secret sauce floating around their crystal ball, guiding their outlook on the economy’s direction.
If investors think the future is looking bright, they buy a futures contract at a price today, hoping that the market will be higher in the future.
If they are right, they sell their contracts later on for a profit. If they’re wrong: see the “sports store” reference at the top of the article.
What are index futures traders telling us about the future today?
Other than for sports teams, life doesn’t happen in a bubble. Like everyone else today, investors live in our uncertain and volatile world.
While we’re all longing for the pandemic to be over and life to get back to normal, right now, futures investors have a different view on the world than most other people.
The best investors (and the ones who can sleep at night) invest within their risk tolerance. Do you know yours?
As of this writing, investors seem optimistic about the economy. Future contracts for the end of September are overwhelmingly up.
Contracts for December and March are trending upwards as well (although that can change as they are relatively far out into the future).
So why are investors feeling more confident about the future than your average consumer?
Professional investors and financial institutions are big futures investors.
These groups have teams of economists and analysts looking at all kinds of indicators to gauge economic trends and other metrics like progress on controlling the pandemic.
Part of their job requires removing the emotion and fear of the data.
As individuals, we’re generally terrible at slowing down to analyze all the different inputs thrown at us.
After all, from an evolutionary perspective, we’re wired to make continuous, split-section decisions about the world around us. As a species, these instincts helped us survive in the purest biological sense of the terms.
However, this survival intuition is absolutely terrible for quickly making an in-depth, data-driven analysis.
Investors and even “speculators” try to look beyond clickbait headlines and mostly meaningless political statements when making their judgments.
While traders or (the people programming algorithms) are still humans, they use data to make an informed guess rather than using gut instincts to make bad trades.
To that, the economy and the world around us is probably better than we think, at least according to the futures market. Only time will tell if the investors knew something the rest of us didn’t.
