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This is a common misconception. Futures contracts are very often used for nonspeculative purposes (e.g. Starbucks locking in prices for buying milk or farmers l

This is a common misconception. Futures contracts are very often used for nonspeculative purposes (e.g. Starbucks locking in prices for buying milk or farmers locking in prices to sell wheat). This is a form of insurance. While the end users are ultimately may net with each other, the intermediaries who take risk matching these parties charge a fee (the spread) for doing so. Why can't the end users trade with each other directly and avoid such fees then? Often they are not in the market at the same time or want to trade different quantities, relying on the intermediaries to resolve these problems.

mattkrause 7y ago
I get that the insurance has a value of its own, but what about the trading of futures specifically? Suppose I buy a biotech stock at $10/share. They make a breakthrough, and the stock shoots up to $110/share. I make +$100/share, but no one has lost the corresponding $100. Suppose I agree to buy an ounce of silver from you for $20 in January. If silver is $21 then, you effectively lose a dollar , since you need to chip in a buck to get me my silver. If it's $19, you can slip a dollar into your own pocket before buying the silver on the spot market. Regardless of how it turns out, the total gain is zero. What am I missing?
- nickles 7y ago
  Suppose a farmer wants to lock in the price of milk produced the farmer's dairy. The farmer wants to sell futures and sees a market of 18.30 / 18.50. These prices are probably being shown by a market maker. The farmer sells the futures to the market maker at 18.30. A few minutes later, Starbucks would like to buy the same contracts, to lock in its costs for the next month. Starbucks buys at 18.50. These two participants have paid the market maker, in total, 0.20 in spread. Here, the spread is the fee the market maker charges for facilitating liquidity. At this point, the net sum between the three participants is still 0. However, we also need to factor in the fees charged by the exchange, any taxes that may be charged on the transaction (for example the SEC fee in equities), clearing fees, and funding costs. On the whole, the transaction between the three participants was negative sum. However, the market maker is running a business by reflecting those costs, and the risk premium, in the spread. Even though this transaction is negative sum, it, presumably, still provides economic value to the farmer and Starbucks.
  - mattkrause 7y ago
    Isn't that example nearly zero-sum (ignoring the spread)? If the spot price for milk goes down later, Starbucks loses a bit of money. If it goes up, the farmer has effectively "paid" for an advance. My point is that futures are by construction zero-sum (ignoring spreads) or negative sum (including them). Thus, any analysis that averages across market participants' P&L will conclude that futures trading is unprofitable[0], except for the market makers. This is true regardless of the savvy of market participants. [0] Obviously, it doesn't capture non-cash considerations. Starbucks and the farmer both might be thrilled with reduced risk. But paper doesn't consider those factors either.
    - nickles 7y ago
      > Isn't that example nearly zero-sum (ignoring the spread)? But ignoring the spread is incorrect, and nearly zero sum is not the same as zero-sum. The spread is the fee that market makers earn for a service they provide. You're also not considering other participants. The price changes you're talking about could be driven entirely by end users, or they could be driven by speculators, arbitrageurs, and others who are providing separate services (price discovery, liquidity, balance sheet, arbitrage, etc.) and are also capturing some of the value. > futures trading is unprofitable[0], except for the market makers If you are explicitly excluding participants who profit by providing financial services to markets, then you are begging the question. > Obviously, it doesn't capture non-cash considerations. Starbucks and the farmer both might be thrilled with reduced risk. Transferring risk can definitely provide economic value (insurance policies exist for this reason), but it should be noted that there are other advantages as well. These futures transactions can help Starbucks manage inventory without needing to maintain large stockpiles of perishable or reduce the volatility of prices charged to consumers.
      - mattkrause 7y ago
        Are you saying that the "misconception" is that it's actually slightly negative-sum, rather than exactly-zero sum? If so, great, I agree. It doesn't change my point at all; if anything it makes it stronger. I am not excluding anyone; I'm trying to explain why I think the result here is not particularly enlightening.
- dbsights 7y ago
  All trades are zero-sum. For any price change in a stock, the money made by one party is equal to the money that could have been made by the other. Given the choice to either buy now or buy later, if the price appreciates, buying later is a loss and if it falls, it is a gain. So in your example with the biotech stock, the person who loses the corresponding $100 is whoever sold it to you prior to the news event. If they had not made that trade, they would be $100 ahead, and if you had not made the trade, you would be $100 behind. Every transaction has a winner and a loser when considered over a period of time.

mattkrause 7y ago

I get that the insurance has a value of its own, but what about the trading of futures specifically? Suppose I buy a biotech stock at $10/share. They make a breakthrough, and the stock shoots up to $110/share. I make +$100/share, but no one has lost the corresponding $100. Suppose I agree to buy an ounce of silver from you for $20 in January. If silver is $21 then, you effectively lose a dollar , since you need to chip in a buck to get me my silver. If it's $19, you can slip a dollar into your own pocket before buying the silver on the spot market. Regardless of how it turns out, the total gain is zero. What am I missing?

nickles 7y ago
Suppose a farmer wants to lock in the price of milk produced the farmer's dairy. The farmer wants to sell futures and sees a market of 18.30 / 18.50. These prices are probably being shown by a market maker. The farmer sells the futures to the market maker at 18.30. A few minutes later, Starbucks would like to buy the same contracts, to lock in its costs for the next month. Starbucks buys at 18.50. These two participants have paid the market maker, in total, 0.20 in spread. Here, the spread is the fee the market maker charges for facilitating liquidity. At this point, the net sum between the three participants is still 0. However, we also need to factor in the fees charged by the exchange, any taxes that may be charged on the transaction (for example the SEC fee in equities), clearing fees, and funding costs. On the whole, the transaction between the three participants was negative sum. However, the market maker is running a business by reflecting those costs, and the risk premium, in the spread. Even though this transaction is negative sum, it, presumably, still provides economic value to the farmer and Starbucks.
- mattkrause 7y ago
  Isn't that example nearly zero-sum (ignoring the spread)? If the spot price for milk goes down later, Starbucks loses a bit of money. If it goes up, the farmer has effectively "paid" for an advance. My point is that futures are by construction zero-sum (ignoring spreads) or negative sum (including them). Thus, any analysis that averages across market participants' P&L will conclude that futures trading is unprofitable[0], except for the market makers. This is true regardless of the savvy of market participants. [0] Obviously, it doesn't capture non-cash considerations. Starbucks and the farmer both might be thrilled with reduced risk. But paper doesn't consider those factors either.
  - nickles 7y ago
    > Isn't that example nearly zero-sum (ignoring the spread)? But ignoring the spread is incorrect, and nearly zero sum is not the same as zero-sum. The spread is the fee that market makers earn for a service they provide. You're also not considering other participants. The price changes you're talking about could be driven entirely by end users, or they could be driven by speculators, arbitrageurs, and others who are providing separate services (price discovery, liquidity, balance sheet, arbitrage, etc.) and are also capturing some of the value. > futures trading is unprofitable[0], except for the market makers If you are explicitly excluding participants who profit by providing financial services to markets, then you are begging the question. > Obviously, it doesn't capture non-cash considerations. Starbucks and the farmer both might be thrilled with reduced risk. Transferring risk can definitely provide economic value (insurance policies exist for this reason), but it should be noted that there are other advantages as well. These futures transactions can help Starbucks manage inventory without needing to maintain large stockpiles of perishable or reduce the volatility of prices charged to consumers.
    - mattkrause 7y ago
      Are you saying that the "misconception" is that it's actually slightly negative-sum, rather than exactly-zero sum? If so, great, I agree. It doesn't change my point at all; if anything it makes it stronger. I am not excluding anyone; I'm trying to explain why I think the result here is not particularly enlightening.
dbsights 7y ago
All trades are zero-sum. For any price change in a stock, the money made by one party is equal to the money that could have been made by the other. Given the choice to either buy now or buy later, if the price appreciates, buying later is a loss and if it falls, it is a gain. So in your example with the biotech stock, the person who loses the corresponding $100 is whoever sold it to you prior to the news event. If they had not made that trade, they would be $100 ahead, and if you had not made the trade, you would be $100 behind. Every transaction has a winner and a loser when considered over a period of time.