Lever the Predictions

The way the stock market works is that if a share of stock trades at $50, you can buy it for $50, and then if it goes up to $55 you can sell it for $55 and make a $5 profit. The way the market for crude oil works is different. If crude oil is trading at $95 per barrel, you can’t really send your broker $95 and get back a barrel of oil. (Where would you put it?) Instead, the normal way to trade crude oil is with futures contracts: You buy a one-month futures contract now at $95, and if oil is trading at $92 or $107 in a month, you lose $3 or make $12, respectively. Someone else is on the other side of the contract: She sells you the contract now at $95, and if oil is trading at $92 or $107 in a month, she makes $3 or loses $12; her losses pay for your winnings and vice versa. I will loosely call this person your “counterparty,” though in fact both you and she deal with the commodities futures exchange and have no direct contact with each other.

You could imagine a world in which you buy the contract now by paying $95, and at expiration you get back $92 or $107 or whatever. Or you could imagine a world in which no money changed hands at the beginning, and you and your counterparty just agreed that, in a month, you’ll pay her $1 for every $1 oil is below $95, and she’ll pay you $1 for every $1 oil is above $95, but no money will change hands between now and then.