Red-Blooded Risk: The Secret History of Wall Street

Farmers and Millers

It seems that every amateur, and a shocking number of professionals, who write about futures markets start with a fairy tale about a farmer selling his wheat crop to a miller, using the futures contract to lock in a price before harvest. There were no farmers involved in setting up futures markets, and they rarely participated. When they did, they were more likely to buy crops than sell them. Moreover, farmers have always been suspicious of futures markets and frequently tried to have them shut down.

Millers, and other processors, do use futures markets, but they generally sell crops, not buy them. If you want to think of a canonical trade, consider a nineteenth-century miller who wants a secure supply of wheat so he can sign large delivery contracts with customers. Of course, he goes to a nearby grain silo that can actually deliver wheat, and contracts for the exact grade and type he wants. Similarly, a farmer who wants to sell his crop goes to a local crop buyer and contracts to sell exactly what he's growing, for delivery to a place he can get the grain to, and without a firm date he might be unable to meet. In the fairy story, futures markets replace these normal, sensible commercial transactions. But a second's thought shows the futures contract is unsuited to that task.

The futures contract does something entirely different. Our miller has gone to a silo to contract for future delivery of wheat. In a typical transaction, the miller will now go to the futures ...