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If futures contracts/exchanges were outlawed, would anything of value be lost in the global economy?
Like other derivatives, futures seem like they are basically gambling for the wealthy more than real investment. What am I missing?
A futures contract is simply a contract that states that you are going to buy or sell a certain amount of a certain commodity at a certain time. If you were not able to do that, it would introduce a significant amount of friction into commerce. Let's say you need 100 barrels of oil for your supply chain. With a future's contract, you sign into a binding agreement that you'll buy those at $X price ahead of time.
This has benefits for both you and the supplier - you have stability, you can rely on 100 barrels at $X in your budget calculations, and be sure that you'll have that 100 barrels of oil even if the market price for oil skyrockets. For the supplier, similarly they get a guaranteed sale.
So I don't think it'd be very reasonable to not allow futures contracts. If you forced everyone to do everyone at the time of exchange, you'd create a lot of instability, which doesn't really help anyone.
Now, what about trading future's contracts? Well, that's gives suppliers and buyers liquidity. For a practical example, let's say a contract fell through and you don't need to make a bunch of things anymore. That 100 barrels of oil is too much. If you were forced to go through with it, then you'd have to find somewhere to store 100 barrels of oil, and then find another seller, and introduce a lot of risk, because maybe the marketprice of oil will drop in the meantime.
In the end, you make widgets, you're not a oil trader! So what you do is you sell your futures contract, usually at a lower price, giving the buyer that difference as payment basically to take over the hassle and risk of dealing with the contract.
If you couldn't sell the future's contract, that contract would become an albatross around your neck if things fall through - this gives you options, it gives you a way to liquify your asset back into cash, which may need at the moment.
Great example/breakdown.
Too many people are financially naive, and don't understand that while there's all these crazy machinations we hear about, they're still based on needed financial instruments. Futures fill a much needed purpose and aren't just magical gambling loophole for the mega wealthy. Shorting is much the same.
There are concerning practices like naked shorting/HFT, although I'll admit i'm too ignorant to know for sure if they're a problem or yet another example of "while dumb stuff happens these do need to exist".
As an aside, it's kinda funny that I first learned about futures because of Trading Places. Lots of people say "you can't do that anymore in film", but I think one of the real cases is having your comedy climax be based on the frozen orange juice concentrate futures market.
Honest question (asked out of total ignorance, and genuine curiosity), what actual need does shorting help fulfill in the financial market? What is the actual benefit to allowing it?
So markets are really about harnessing the wisdom of the crowds, and the goal we want from the market is that the things being traded on the market should have the "correct" price by the end.
Buying and selling things is a given, but the more complicated market trades are about information density. When you buy or sell, you are providing information, but it's very low fidelity, when you think about it. If I think Apple is going to be valued at $200 tomorrow, I would buy Apple stock today. If I think Apple is going to be valued at $500/stock, I would still buy Apple stock. Really, if I think Apple's stock will be anything higher tomorrow, I'll buy Apple stock, and vice versa.
Actual shorting, call options, put options, transmit more information. I think Apple's stock will not just be higher, but be higher than $220.
Furthermore, companies will stack these together to form even more complicated, and even more information dense, trades. If you think Apple's stock will go up, it's common to both buy call options AND put options - that is, you're betting it'll go up AND it'll go down. Obviously not in the same magnitude - the point is insurance, basically. If you're wrong, the puts will profit, which means that you won't lose as much money. But if Apple does go up, the loss from the put also caps your profits. So you're lowering your profits to have lower risk. This is called hedging, by the way, and is where the hedge in hedgefund comes from.
So this is a very information dense trade - now you're setting a continuous range that you think it will be, because if it goes up too high your puts will really limit how much you'll make. So you want it to go up, but not too far up either.
From the market's point of view, the benefit is that price discovery can be expedited since players can transmit much more information. For people in the market, they can buy things when they otherwise may not be able - being able to hedge your trades can be important for risk management, for instance.
To add on to other good answers, I think it's important to explain why higher stock market prices can be bad. "Price discovery" is a technical term that doesn't really get into that.
Much like cryptocurrency advocates and home owners, many investors tend to assume that rising prices are good, because you make more money. Graph goes up, that's good news, and if it goes down that's bad news. And that's often true even for non-investors because stock market crashes are associated with bad things like recessions and layoffs.
But stock market prices are predictions about how well a company will do. People think they can predict the future and get optimistic. If there's no way to bet against a stock, the advocates will buy it and everyone else will stay away, resulting in bubbles even when there's widespread skepticism. A bubble like that will burst when it becomes clear even to advocates that people's rosy expectations aren't going to happen.
Keeping these expectations in check is easier when there's incentive for finding out bad news about a company and making it generally available. Like with investigative journalism, it's a sort of muckraking that many people don't like but it's actually important.
(This isn't an argument for shorts in particular, though, just for having ways to bet against stock.)
To add one to the answers you've gotten, here's (very roughly) how short's work. They are basically just a loan.
You decide that company X is probably going to do poorly and it's currently trading at $100 a share. So you go out and "borrow" share, with the agreement that you will return the share on Y date.
In theory, you could just sit on the share and do nothing with it, and then return it when the date is up (there's interest on this like a normal loan however so you'd lose a bit).
Instead though you sell the share instantly for $100. Then at Y date, lets say the stock is now worth only $50 a share. You buy that up and then give it back to the original owner. They get their share back, and you've made $50 net (minus interest). Even better, you got money NOW which is technically worth more than money later from a financial standpoint.
Buuuut of course the inverse can happen. The price could skyrocket to $200, and now you're on the hook for that and now lose $100.
The obvious question is "what if you can't afford it", to which the answer is you're (mostly) not allowed to do that. You have to have enough money in your account to borrow the loan in the first place. You'd probably have to have at least $150 in your account to borrow the $100 stock (vast generalization here), and you'll get margin called if it looks like it's going to hit a price you can't afford. So at around the $150 price, your position is closed out, you're forced to buy and return the stock, and your account is wiped out. It could PLUMMET to $1 after that, but you've already lost the stock and the money because if it doesn't they wind up on the hook. This is in part because a short has INFINITE exposure. If I buy $1000 of stock and the company goes under, i lose my $1000. If i short $1000 worth of stock, and the company becomes the next apple, I could be on the hook for millions.
Looking at it in this light, it's another liquidity tool and a way to balance out the "line goes up" issues. You can take $1000 and turn it into $1500 if stocks go up, but shorting does allow you to take $1000 and turn it into $1500 if it goes down as well (in a sort of reverse manner where you make the money first).
Obviously, there's issues with how this is used by large companies. You can try to short the hell out of a stock, hoping it'll hit 0 (or something stupid cheap) so there's nothing to buy back. How legal this is is questionable (and how enforceable). Further larger institutions can take crazy positions, say they're good for it, and then if it turns out badly, pull the "well if we fail it's a massive issue so you're just going to have to wait it out". Variations of this are what was claimed during the gamestop issue, and is frankly too complicated for me to easily parse the bullshit from the facts, and maybe still ongoing depending on who you ask.
I think there's lots of room to better regulate the market, (and there have been several rules on shorting over the years), but at the end of the day "loaning" is a pretty core financial concept.
I think there's a lot of misinformation about how shorting actually works. It's not something that magically makes stocks go down - it's a market signal, and if you own a bunch of stock and suddenly see a bunch of short positions against it, it'll make you think, "huh, I wonder what they know that I don't".
Furthermore, in the short term, the stock price of a company doesn't really have any effect on the operation of the business. It comes into play if you want to raise money by selling capital or when you try to borrow money, as a lower market cap can make banks less likely to lend you money. But otherwise, if you're a company with healthy free cash flow, then it really doesn't do anything.
People who are shorting have to pay interest on their loans, so they're on the clock. If you're actually a good company, they'll take an L with time.
Shorting is definitely not illegal. That being said, it's a very risky position, and usually only done by firms specializing in shorts. Put options or selling call options are more common "short" positions, as they are still bets that a stock goes down, but isn't as extreme.
Naked shorts is illegal, but that's because it can risks failure-to-deliver. With naked shorts, you sell stocks before you even get a loan for them. This introduces the possibility of instability, because if you can't get the loan by the time to deliver, then... you don't have any stock to sell anyway.
This is really not what happened with gamestop.
I think i conveyed my points poorly but I agree with you.
Shorting doesn't magically make the price drop, but it clearly can have that affect on the market since it's about reading signals, and mass shorting has been a strategy used to try and do exactly that (to limited success despite what you usually hear about).
And yeah I didn't make clear enough i'm not saying that's what happened with gamestop, only that it's one of the many arguments being used by those who think shady stuff is going on. Again I just don't have the knowledge to comment intelligently on that, and probably should've just left it out.
Ah, viewing it from the mechanical perspective, as that of essentially just a form of loan, makes it easier to understand, and makes much more sense to me. Thanks!
IIRC it incentivizes individuals and orgs to act as watchdogs, and identify happenings in publicly traded companies that could bring the stock price down.
Edit: and publicize them.
Shorters will say that incentivizes traders to do deeper research into publicly traded companies and expose mismanagement or wrongdoing that the company is involved in. This helps make sure that companies are properly valued in theory.
I am not a financier. But I think there are two concepts at play when someone mentions "shorting."
To add to other comments, shorts can also be used as a simple tool to fine-tune one's exposure, without being a "bet that the stock price will go down."
Suppose I'm employed in the US tech industry. My own personal fortunes are tied to the overall health of the tech sector, so I might feel uncomfortable taking on additional risk by also having my retirement savings invested in tech. If I can invest in everything-but-tech, then there's some diversification: if tech does well then my job (probably) goes well, but it tech goes poorly and I'm out of a job at least my savings aren't wiped out.
I could build this portfolio the hard way, by buying individual stocks corresponding to "everything but tech." There are 500 companies in the S&P500 (natch), of which 67 are "Information Technology" companies, so I could do this trade by buying proportional amounts of the remaining 443 companies. That's a lot.
On the other hand, I could also do something very similar with two trades: buying an S&P500 index fund and shorting a technology fund (like one tracking the Nasdaq100) in a lesser amount. If technology goes up then the S&P500 goes up (making me money) and the Nasdaq-100 also goes up (losing me money), coming out as a wash; if technology goes down then I lose money on the S&P but gain money on the Nasdaq short. Overall my portfolio is close to tech-neutral, with just two trades.
Incidentally, this is exactly what happened with onions. Thanks to a notorious case of market manipulation in the 50s, the US Congress passed the Onion Futures Act that specifically banned trading in onion futures.
This has provided an interesting natural experiment in US agriculture: every other crop can be traded on the futures market, but not onions. Per that Wikipedia article, there's been some scholarly debate about whether the futures ban made price volatility worse or better. A Fortune magazine article in 2008 picked on recent data to note that onion prices were more volatile than corn prices despite similar weather-related effects.
Wouldn’t Corn be a terrible crop to compare to as it has so many subsidies?
It would probably depend on the subsidy. If the subsidies are just a certain payment per bushel, then I'd expect them to affect the level of the corn price but not its changes from week to week. If instead subsidies come in the form of minimum payments or purchase agreements, then it might have a stronger affect on volatility.
To be really rigorous, I think a study would want to construct a "synthetic onion" by matching prices over time. Maybe an onion is something like (2×corn - 1.2×tomato + 0.125×wheat); then the volatility of real onions could be compared to that of synthetic onions, where each component has a futures market.
What you say makes sense somewhat within the context of commodities....but not so much a company itself.
Shorts in particular scream "I think you're not worth that much, so therefore I should profit off those who do." It's not an essential function outside of financial instruments being propped up around their existence.
How about a radical reimagining about what investing is? In a way that doesn't need unintuituve derivatives.
You can only invest in a company, or sell your stake after 5 years. Your returns on investment come purely in the from of dividends and possibly payout from dissolving of company assets.
There's not really any difference with equity markets.
Yeah, that's what a short is. You think the true price of an equity is lower than the market price - the potential profit you may earn is the "fee" the market gives you for price discovery. It's equally as important that a price for an item in a market is not too high as it is that it isn't too low. There's nothing particularly wrong with it.
Actually shorting, as in, selling loaned stock, is also very rare, as it's a fairly extreme position. It's mostly done by specialized firms who usually make large short positions against actual ponzi scheme level companies. Other types of short positions like puts or sold calls are more common.
Like I said in another post, the function of all of this is increased fidelity of information for price discovery. If you limit the types of trades actors in a market can make, you make price discovery less accurate, and increase instability within the market from decreased liquidity.
This would cripple the financial system, and not in a good way. If you were only allowed to sell after five years, you'd only invest in sure things, right? Why risk your money on a new soda manufacturer when coca cola will definitely still be around?
You'd see a massive centralisation in which only established quasi-monopolies would be able to raise any cash at all.
Futures serve as insurance for large businesses. If you’re coca-cola, for example, a huge spike in aluminum prices is a giant systemic risk to your business. If you can use futures contracts to lock in aluminum prices over the next x years, you can remove most of the risk. You’re usually paying a premium to do it, but you do that with other forms of insurance too.