Trading Places is one of my
favorite movies of all time. However, I
have many people have always felt a
twinge of guilt when they watched the
movie with other people.
Here's the deep dark secret: most
people don't really understand what
happened during the climatic scene at
the commodities exchange! Lucky for all
of us, the answer is very simple:
With the authentic orange crop report indicating
a good harvest of fresh oranges, frozen
concentrated
orange juice (FCOJ) would be less important
to food producers and so would be likely to drop
in price once traders heard the news. However,
by way of a fraudulent report, the Duke brothers
are led to believe that the orange harvest would
be less successful, necessitating greater demand
for stockpiled FCOJ in orange products in the
coming year, thereby driving the price up. By
capitalizing on this knowledge (and the Duke
brothers' missteps), the
protagonists are able to profit by
manipulating the
futures market.
The Duke brothers
open the market by purchasing enormous quantities of FCOJ
futures--even at relatively high prices--because they incorrectly expect that the
crop report (falsely suggesting a greater
need for stockpiled orange juice) will
create a demand at even higher
prices, securing them a profit. The
Duke Brothers' buying leads other traders to
believe that the Dukes are trying to
corner the market, causing a buying
frenzy as the traders piggyback
on the Dukes' trading.
However, like conventional stock,
futures contracts can be sold even when
the seller does not yet own any of the
commodity. A contract to sell, say, 15,000
pounds of FCOJ at $1.50 per pound in
February merely indicates the seller's
obligation to provide and the buyer's
obligation to purchase the product at the
specified price and time. It does not matter
how or where the seller gets the product, as
long as, one way or another, he is able to
deliver it at that price at that time, even
if it results in a sale at a loss to him.
This type of sale is called a short
or short selling.
In this case, Winthorpe and
Valentine short or sell IOUs FCOJ
futures at a price inflated by the Dukes
themselves. Then, when the price falls — first
as a result of Winthorpe and Valentine's
eager selling, then to a much greater degree
upon the release of the real crop
report indicating a good harvest — Winthorpe
and Valentine cover their
short sales. Thus, they buy back every futures contract
or IOU they had previously sold at the high
price for a much lower price,
resulting in an extraordinary profit.
In the
futures market, the value of the contracts
you can purchase is limited by the balance
of your margin account. With a typical
requirement of 4%, you can purchase roughly
25 times the balance of your margin account.
Though it is not stated in the movie exactly
how much they make, if they invested roughly
$500,000 from a combination of Winthorpe/Valentine's
investment, the Dukes' money from buying the
"fake" report from a fake Clarence Beeks,
and Coleman's and Ophelia's savings, they
would have turned it into over $10 million.
It is strongly implied that they purchased
additional futures
on margin and made dozens (or hundreds)
of millions more, since a lesser amount
would not bankrupt the Dukes.
When it
turns out that the leaked report they were
given was fraudulent and the true report is
revealed, the price begins to plummet before
the Dukes are able to sell off their contracts.
This leaves them with an obligation to buy
millions of pounds of FCOJ at a price more
than a dollar per pound higher than they can
sell them for, bankrupting them.
The Dukes
are also trading on margin, in order to
magnify their profits (or losses, as it
turns out). The first words that the
exchange representative says to them after
their disastrous trading session are "Margin
call, gentlemen," requiring them to
deposit more money with the exchange to
cover their open loss-making position.
Randolph whines, "You know perfectly well
that we don't have $394 million in cash!"
Since their open position is hundreds of
millions of dollars in the red, leaving no
further margin to deposit, they are
effectively ruined.
The price change on FCOJ
futures that generated Winthorpe and
Valentine's huge profit would be unlikely in
the real FCOJ futures market. The exchange
that houses the FCOJ futures trading imposes
a daily limit of 10 cents per pound on the
price movement of the near month contract
from its previous day's settlement price.
Most commodities futures contracts have
daily limits. After the FCOJ price is 10
cents away from the prior settlement price,
trading is halted and the market is referred
to as "limit up" or "limit down". Trading
reopens if prices are again within the
limit, and the next day the price can change
10 cents again. The price limit can be
widened under certain market conditions.
Leadership Focus