Lesson 5: "Time" and "Money"

The differences between investing in stocks
and investing in futures contracts are
"time" and "money"

Time. The best way to understand futures contracts is to consider one's hometown and the number of students who will graduate in a particular graduating class. Let's suppose that you live in a large city and that "Central High School" is scheduled to graduate 800 students this year. Pretend that the senior class of 1999 had 804 graduating members and the class of 1998 had 796. Your neighbor is the type of person who likes to make friendly little wagers and she suggests to you that you wager on the number of students who will graduate from "CHS" on June 15th of 2001. Here is how the wager might work.

1. The class of 2000 has 800 graduating seniors.

2. Your wager will be based on 800 students (the average number of graduating students for the past three years).

3. Your neighbor is a very accommodating person and she will allow you to make the first bet.

4. You can bet that the class of 2001 will graduate more than 800 students (you will be long, expecting a higher number than 800).

5. Or, you can bet that the class of 2001 will graduate less than 800 students (you will be short, expecting a lesser number than 800).

6. Whichever bet you decide to make (long or short) your neighbor will take the other side. If you go "long", she will go "short". If you go "short", she will go "long".

7. The amount of money you agree to bet will be $1 for each student above or below 800. If 803 students graduate, the person who went "long" will earn $3 and the person who went "short" will lose $3. If 795 students graduate, the person who went "long" will lose $5 and the person who went "short" will earn $5.

8. The bet will be paid off (a) on graduation day when the number of graduates is actually known or (b) at any time prior to graduation day when you and your neighbor decide to use the then present number of students in the graduating class of 2001 to settle the amount owed under the bet.

 

Time means that the bet will end by a date certain or at an earlier date. Time is one of the essential differences between investing in stocks and investing in futures contracts. When you invest in futures contracts, there is always a "time" at which you must end your position and settle up the money owed or money owed to you. When investing in stocks, there is no inherent element of time that limits how long you can own your equity position. Two examples should illustrate this difference.

1. If you bet that soybean futures will be higher than $4.00 by November of 2002 then you have established a "time element" which will now become an essential part of your investment program.

2. If you buy 100 shares of stock of "Imaginary River Co." there is "no time element" that controls your investment.

 

Money. The second difference between investing in stocks and investing in futures contracts is the amount of money required to make the investment. Let's return to "Central High School" to understand this difference.

Suppose that you and your friend wanted a guarantee that when the Class of 2001 did graduate, whoever lost the wager would pay the $1 per student bet. How much money should each of you deposit to guarantee that the winner of the bet would be paid? There would be no need to put up $800 because it is probable that neither of you will lose $800. Why? Because the average graduating class size at "CHS" has been 800, the class that will graduate in 2001 has 814 current members and it is unlikely that this class will add 800 or lose 800 students before graduation date. A reasonable person would expect a graduating class in the year 2001 to be between 780 and 820 students. If the greatest loss to be suffered by a "long" bet is $20 and if the greatest loss to be suffered by a "short" bet is $20, you and your neighbor may agree to each deposit $20 with a neutral party to assure that whoever loses the bet will pay what is owed. Remember that you and your neighbor are not buying or selling anything. You are simply entering into an agreement (call it a "contract") which calls for one of you to pay $1 per student for every student above 800 that graduates in the year 2001 and calls upon the other to pay $1 per student if less than 800 students graduate in 2001. You are not buying 800 students. You are buying nothing. You are entering into a contract to win or lose based on the number of students who finally graduate from "CHS" on June 15th, 2001.

You each put $20 into the hands of a neutral party and proceed to watch the class of 2001 as new members enroll in school and present members withdraw. Every time a new student enrolls at "CHS" your bet will be affected and every time a student leaves school your bet will be affected. And while the enrollment may fluctuate around 800 students this does not mean you should have to put up $800 for a bet which probably involves no more than $20 of risk. Why should you put up more than $20? There is no reason why you should and you don't. The fact that there are 800 students in the class is not significant. What you are betting on is how many students above or below 800 will graduate and not the number 800 itself.

When you invest in stocks, however, everything is different. If you buy ten percent of Imaginary River Corporation and this company has assets worth $100 you probably should pay at least 10% of $100 or $10 for your interest. With regard to stocks, you are actually buying something. You are buying equity in a corporation. You are buying a share of ownership. What the corporation has in assets or earnings will determine what you will pay. When you buy stocks, you buy ownership.

When you enter into a futures contract regarding the number of graduates in the class of 2001 you are buying nothing. You are not buying the class of 2001. You are not buying 1% of the class of 2001. You are simply entering into an agreement whose value will be determined by the number of students who graduate from "CHS" on June 15th, 2001.

When you enter into a futures contract and you "go long soybeans" you are not buying soybeans. When you enter into a futures contract and "go short soybeans" you are still not buying soybeans. All you are doing is entering into a futures contract whose value will be determined by the price of soybeans at the "time" you decide to end your futures contract or the time arrives when it is automatically ended.

1. Remember,

2. Futures contracts are always "time specific". They always have an expiration date connected with them.

3. Stock ownership is almost "never time specific". There is almost never an expiration date connected with stocks.

4. Futures contracts do not require payment in full because you are not buying ownership. You are entering into a contract.

5. Stock purchases normally do require payment in full because you are buying ownership, a share of something of value. You pay in full because you own something.

 

"Time and Money." In upcoming lessons, I am going to show you how to use each to your own advantage. In some cases, you will want to use "money" to profit from an unusual situation. In other circumstances it will be easier to use the element of "time" to make the greater profit. You should know how and when to use each.