So you’ve bought a Weather Future yesterday, specifically for rainfall next Tuesday. You entered into the agreement with the expectation that there might be 2mm of rain that day. If there’s no rain at all, you’re on the hook to pay out $20 (10 * -2). But if there’s lots of rain, its your pay day (5mm pays you (5-2) * 10 or $30).

But what is that future worth today?

At Massive Rainfall, we use a “Mark to Market” to basically follow the forecasts and “lock” money in either your account or the account of your counter-party. Let’s say the forecast as of today expects 5mm of rain. Although nothing is paid to you or them, the $30 in their account is locked and cannot be spent. Tomorrow, if the forecast changes to 3mm, the lock is adjusted downward to $10 = (3mm-2mm) * 10. Now if the final actual weather is 1mm of rain then the payout is in fact against you (1mm – 2mm) * 10 or negative $10.

It doesn’t matter that previous forecasts would have paid out to you – unless you clear your position by entering into an offsetting transaction. If you decided to lock in your 5mm of rain today, you would sell a future at 5mm. On the actual day, your buy would pay -$10, but your sell would pay $40 netting you $30 in profit. Cash in your account will be locked for each day (selling the 5mm will give you $20 when the forecast drops to 3mm [(3mm-5mm) * 10] and $10 (3mm-2mm)*10=$10 and then finally (5mm-1mm)*10 = $40 for the sell future, -$10 for the buy future – still netting you $30. A table would probably make this clearer.

This leads to the “take the money and run” syndrome. When a weather future is in the money prior to the forecast, there is no guarantee that it will be the final forecast. Volatility can be your friend but be forewarned – it can be a bit of a jerk too.

But what if you took that money today, and watched the forecast change to a Massive Rainfall that paid out $180, how could you swallow that?