A recent headline and story on CNBC caught my eye: “A risky natural gas bet gone awry least to weepy YouTube confessional video.” Apparently, money manager James Cordier had piled into a risky position in natural gas derivatives without hedging to prevent steep losses. Betting that natural gas prices would decline, Cordier was caught off guard when prices suddenly spiked 18%, resulting in catastrophic losses for his clients. With no excuse for the massive blunder, a teary-eyed Cordier issued a mea culpa to his clients on YouTube.
This was a stark reminder to me of why investors should steer clear of investing in futures contracts or derivatives of any kind because any investment whose value is linked to a specified time horizon is not really an investment – it’s speculation. Speculating may be fine if the money your using is entirely expendable – meaning you can afford to lose it all, and still have your future financial security in place. However, unlike placing a bet on a horse race or at the roulette wheel where your losses are limited to the amount of your bet, the losses on a futures contract can extend well beyond the amount paid for the contract.
Are Futures Contracts Investments or Speculation?
The best way to understand how a futures contract works is to compare it to an investment in stocks. Whereas a stock represents ownership in a company, a futures contract doesn’t represent ownership in an underlying asset. It is a legally binding contract in which a buyer agrees to accept delivery of a certain quantity of an asset and a seller agrees to deliver it by a set expiration date.
While many companies utilize futures contracts as a way to manage their exposure to a price swing in commodities consumed in their business (i.e., airline companies and the price of fuel), most futures traders don’t actually want to take delivery of an asset. Rather, they seek to profit off the price changes in the contract itself by selling it before the expiration date.
The real danger with futures contracts is that you are only required to put up a portion of the full contract value to create a position – known as the initial margin. For example, if you believe the price of oil is going to rise from $55 to $60 a barrel by April, you purchase a contract for $55, which gives you control over 1,000 barrels worth $55,000. Most brokers require a minimum margin payment of a few thousand dollars for a contract.
If the price goes up and you sell the contract at $60, you make $5,000 per contract. However, if the price drops to $50 and you sell to close out the position before the expiration date, you lose $5,000, which can be more than your initial margin payment. Because commodities brokers allow traders to leverage 10 to 1 or even 20 to 1, a wrong price move could cost you substantially more than your investment.
With Futures Contracts Time is Your Enemy, Not Your Friend
One of the fundamental principles of sound investing is to allow time to work in your favor. Investors establish an investment time horizon based on their long-term goals. Understanding that short-term concerns can cause stock prices to fluctuate and even decline, the time element, along with the historical trend of the stock market, allows investors to perceive declines as temporary. Historically, when patience and discipline are exercised, investors with a long-term investment strategy have been rewarded with positive returns. For them, time is their friend.
However, investing in futures contracts automatically locks you into a short-term time horizon, during which price movements are dictated by factors beyond anyone’s control with very little time to correct. Yes, advanced futures traders can gain some advantage with sophisticated technical analysis tools but, for most investors, it’s a crapshoot.
It was a tragedy for James Cordier, a highly sophisticated futures trader, and his clients, that the price of natural gas moved against him. He was unhedged, which was an unwise position to take with so much at stake. But it is an opportunity for me to remind my clients, and any investor who will listen, why it’s unwise to invest in anything where the value of your investment can drop to zero at some predetermined time or date.