How futures trading works: a thread

(disclaimer: I am not an expert but I did work as a quant researcher at a futures trading firm for 8 months so that's better than nothing)

The Finance 101 story of futures goes like this:

A farmer wants to plant some wheat today and harvest it in September. The price is $3/bushel today, but if it drops to $2 by September she'll go broke. Meanwhile a baker wants to build a bakery and sell some bread in September, but if wheat rises to $4 she'll go broke.

So they enter into a forward (not futures, I'll get to that) contract, where the farmer agrees to sell the wheat to the baker for $3 in September. That way, the farmer and the baker can both be confident that neither will go broke in September.

This is cute, but how do the farmer and the baker find each other and work out the details?

Enter the CME. The CME comes along and says, hey, why don't you just cut in the middleman? We'll facilitate contracts with standardized terms and regular delivery dates (for a small fee)

The standardized contracts through the exchange are called Futures contracts. So now, the farmer goes to the CME and asks "hey do you have any buyers at $3 for September?", and the baker goes to the CME and asks "hey do you have any sellers at $3 for September?"

And the CME writes a futures contract obligating the Farmer to deliver wheat to be sold for $3 in September, and the Baker to show up and buy wheat for $3 in September. We say that the Farmer is taking the "short" side of the contract, and the Baker is taking the "long" side.

Since contracts are now all through the CME, this creates new opportunities: "market making" (aka trading aka speculation). Maybe it's my personal belief that the price of wheat will go to $4 in September. Then I might go long on a futures contract at $3 even if I'm not a baker.

If I'm right, I'll be able to buy wheat in September for $3 when the market price is $4. I can turn right around and sell it and make a tidy profit.

Or, I might believe that wheat is going to go to $2. Then I can go short on a futures contract at $3 even though I'm not a farmer. If I'm right, I can buy wheat for $2 and then sell it for $3.

But here's where things get really crazy: say the price of a September futures contract is $3 and I (a trader, not a farmer or a baker) decide to go long. That means I'm entering an agreement to buy 1000 bushels of wheat for $3 each in September.

Let's say the price of a September futures contract becomes $4 tomorrow. What I can do now is go short on a September contract at $4, meaning I'm agreeing to to sell 1000 bushels of wheat for $4 each in September.

Since both of these contracts are with the CME, the CME will figure out that my net change in bushels is going to be 0, and that I'll make $1000 from the transactions. So they go, "you know what, don't even show up in September. Here's the $1000 you would have made."

So I can promise to buy and sell wheat, and as long as I'm careful to make sure that I've promised to buy exactly as much as I've promised to sell before it's time for delivery, I never even have to leave my basement.

So that's what futures traders do. They participate in this market with no intention of ever actually exchanging the physical commodities underlying the contracts.

In my example where I bought September wheat for $3 and sold September wheat for $4, the people on the other sides of those trades could have been other futures traders. Thousands of promises of bushels of wheat bought and sold to people with no intention of delivering.

#wtioil futures are for 1000 barrels. So if am long a May $WTI contract on the expiry date (today), that means I'm on the hook for showing up to Cushing, OK sometime in May to buy 1000 barrels at whatever price I agreed to when I went long.

As a trader, if I went long yesterday at $20, I did that expecting that I would go into a short contract today in order to avoid delivery—*not* expecting to actually exchange any oil for $20. As a trader, I have *zero* intention of actually going to Cushing to buy oil.

So as expiry approaches, I'll "sell" at just about *any* price in order avoid having to actually buy thousands of barrels of oil for $20. But I'm not actually selling oil physical oil at a negative price, I'm just paying a big premium to cancel out my existing agreements to buy.

Meanwhile, as a trader, if I went short yesterday at $20, I did that expecting that the price would come down and I could go long today to avoid delivery. I want to buy today at the absolute lowest price I can today in order to make money canceling out my short position.

So anyway all of this is to say that I am curious how much of this negative oil price trading was actually about trading physical barrels of oil. Most of the volume in futures trading is done without any of the underlying asset moving at all.

I bet not that many people *actually* got paid to pick up physical barrels of oil (i.e. that physical barrels of oil were sold for a negative price), but I don't think that data is widely available