Futures trading involves buying and selling of contracts attached to a specific commodity or asset in order to guard against losses arising from volatile prices. In its bare form, a future is simply a promise by a buyer to a seller that he/she will purchase a certain commodity at an agreed price and time.
Futures are common in the airline industry and are used to guard against fuel price hikes, or in agriculture to guard against price/quantity fluctuations. A supermarket or food processor would enter into a contract with a farmer that would guarantee that no matter what, the farmer would sell their produce to the supermarket at an agreed price. The timeline of the purchase is also agreed upon and is known as contract expiry/maturity date.
The Basics Of Futures Trading
You can be involved in futures in three forms, as a non-trader, a day trader and as a long-term trader. Non-traders trade in futures because of an underlying interest in the commodity – they are either the consumers or producers of the product. For example, a farmer and supermarket in a futures contract are considered non-traders because they own and use the commodity attached to the future.
Day traders buy and sell future contracts without the intent of taking possession of the underlying commodity. For instance, a day trader will buy a maize futures contract at the Ksh.50 per Kg and sell it on the same day at Ksh.50.4 per Kg. A long-term trader, on the other hand, would buy the maize futures contract at Ksh.50 per Kg and sell it six months later at Ksh.60 per Kg. Both the day and long-term trader sell their contracts before their expiry dates, they don’t take possession of the commodity attached to the contract.
You can only buy and sell futures contracts in a futures marketplace called an exchange, which is usually divided into commodity exchanges and currency exchanges. Commodity exchanges are used for trade in products like oil, agricultural goods etc. while currency exchanges allow trade in various currencies; the US dollar, British pound, Kenyan shilling etc. The world’s largest futures exchange is the Chicago Mercantile Exchange (CME) in the USA. Africa’s exchanges include the Africa Mercantile Exchange (AFMX) in Nairobi Kenya and the South African Futures Exchange SAFEx that has been in operation since 1990. You can trade in all these exchanges by working with brokers in the respective exchanges.
Just like in the stock exchange, future trading requires the help of a broker who charges a commission on trades made. On the other hand, online exchanges such as Ally allow you to trade directly without a broker. In order to trade, traders are required to have a minimum amount of money in their futures account, which is set by the individual exchanges.
Why Are Futures Contracts Beneficial To Farmers
- Advanced Sale of Harvests
Farmers can get guaranteed buyers by selling their produce in form of futures contracts even before harvest time. While this aids the farmer, the contract buyer benefits from the assurance of getting an agreed quantity of produce at a specified time. Agricultural prices are fickle and can easily experience sharp declines and increases influenced by uncontrollable factors, such as weather changes and pest attacks. As such, futures cushion both farmers and buyers against losses from price fluctuations.
- Easier financing
According to a report by the International Finance Corporation, approximately 1% of banks’ lending in Africa goes to the agriculture sector. Additionally, only 4.7 % of rural adults in developing countries have loans from formal financial institutions. Such low lending numbers financially exclude farmers and hamper their ability to buy better equipment, seeds or even educate their children. However, with futures, the contracts and receipts of goods stored in warehouses awaiting sale can be used by farmers as collateral. This lowers the risks banks face in lending to the agriculture sector and boosts finance penetration.
- Price Transparency
Unscrupulous middlemen, as currently is the case, exploit farmers partly due to a lack of knowledge of the worth of their produce. If Kenyan farmers become active in the futures market, pricing data from the futures exchanges they trade in will become more relevant in the local context; and since such information is in the public domain, farmers will be better equipped to negotiate deals with buyers. While investors interested in agriculture will better understand the risks and possible potential return on investment if they venture into farming.
The Agricultural Sector: Why Modernization Is The Way For The Future