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•40 The 100 Greatest Business Ideas of All Time

Cocoa is a traditional futures market that started trading in 1926. Commodity
suppliers sell some or part of their future crops forward. That is, they agree a price
and a volume of product with a trader before all the uncertainties become known.
The timing in the cocoa market of this is up to 21 months ahead. Farmers can now
sleep soundly knowing that a proportion of their income is protected whatever the
outcome at harvest time. The great idea is as simple as that.

But, of course, then the complications cut in. Producers have an interest in
concealing the true size and condition of their crops. News of impending shortages
will drive prices up; the prospect of a bumper harvest will take prices in the opposite
direction. Since there is active trading in these futures, the original buyer can sell
the contract on at a profit or loss.

Usually producers work out just how much of the crop they want to sell forward
so that if there is a shortage and higher prices are available they will be able to take
advantage of these for at least some of their produce. The proportion ‘hedged’ or
‘insured’ limits the risk to whatever level the producer deems acceptable.

The chocolate manufacturers are also playing a careful game. Their wish is to
guarantee a minimum amount of cocoa whilst at the same time trying to achieve the
minimum average price they can. They will buy forward only if they think the price
is likely to rise.

This is the classic role of the commodities futures market, providing a way of
hedging risk due to uncertainty about the supply and demand for basic materials
and the pricing consequences that follow.

The great idea of hedging has been expanded to allow futures trading on stocks
and shares. In this way an investor can buy call options at a price set at that time for
a trade to occur at a fixed time in the future. Either side in this transaction can thus
increase the potential reward of a share price rise by using gearing. It works like this.

Suppose you believe, for whatever reason, that the price of shares in Example
Company PLC (ECP) is going to rise over the next few months, so you can buy an
option in the futures market. Take these numbers as an example.

The share price of ECP is currently 658 pence. You believe that it could rise