Did you know that you can invest in the weather? Yes, that’s right. The weather. You can take a financial gamble that the temperature in Sacramento will be one degree warmer than average, or even bet that it will be five degrees cooler.

Too dull for your portfolio?

How about putting some money down on the amount of snowfall next winter in Boston? Or frost in Amsterdam? Or hurricanes in the Gulf of Mexico?

Each of these investments can be made in an investment product category called weather futures. Traded through the Chicago Mercantile Exchange, these weather contracts provide investors a highly risky and speculative chance to control – financially at least – that most uncontrollable matriarch, Mother Nature.

Not quite sure how on Earth this could possibly work? Don’t worry, you’re not alone. Let’s start at the beginning.

How Futures Work: A Case Study Using Captain Crunch

At their heart, weather futures trade just like commodity futures. Commodity futures are the backbone of economic trading system surrounding goods like oil and lumber and pork bellies.

So how does a basic futures contract work? Well, let’s say that you are Captain Horatio Magellan Crunch, retired naval hero and maker of a popular eponymous breakfast cereal. To make your delicious crunchy nuggets, you need about 100 tons of corn per month. Let’s say that you’re worried about the increasing use of corn-based Ethanol in large commercial vehicles driving up the cost of corn and subsequently cutting into your profits. Buying a futures contract lets you lay claim to some of next season’s corn now while prices are still relatively low.

A futures contract is, at its simplest, a financial tool that allows you to do the equivalent of licking the last piece of pizza so that the other kids can’t have it. It’s a way for consumers to claim dibs on goods before they’re ready to use them. By putting a little extra money down now, you can lock in a date and a price for the goods you want, and hedge against the risk of the price going up in the future.

So, let’s say you, the Captain, want to lay claim to about 1,200 tons of corn for next year’s production. You would buy a futures contract promising to pay a specified price per ton for delivery on a specific date. For example, the contract might state that you will pay $100 per ton for 1,200 tons on Jan 1 of 2010. Your up-front cost for the contract is $3 per ton, or $3,600, not a deposit on the future purchase mind you, but the cost you pay to lock in the future price today. You’re willing to pay a little extra ($103 total per ton rather than the going rate of $100) because you’re worried about the price of corn going up.

If corn goes up to $200 per ton by January, you’re thrilled because you’ve got the right to buy it at only $100. You’ve saved yourself almost $100 per ton. But if it goes down, you’ve wound up costing yourself more than if you had done nothing at all. You’ll sell the contract at an almost total loss and be out most of the $3600.

The same financial principles are at stake when your old college roommate options his blockbuster screenplay to Paramount. Because getting a film from page to screen is such a long and iffy process, and because most films that get pitched never wind up being made, studios and producers prefer to option a screenplay rather than buy it outright, reserving the right to buy the script when the picture actually gets greenlighted. An option contract of this type might simply state that Paramount reserves the right to buy your buddy’s script anytime within the next year for $1 million dollars.

For this option, they’re willing to pay your old roommate $5,000. Paramount is not promising to buy the script, they’re just keeping the scavengers from Miramax from buying it up during the next year while they try to firm up Mandy Moore for the leading role.

If a year goes buy, and Paramount decides that they’re not going to make the picture, your friend can go shop his script to the other studios. Some scripts are optioned ten times before the film actually gets made.

From Ancient Babylon to Ralph Bellamy: The History of Futures Trading

Archeological evidence points to some type of futures contracts being in use as long ago as 6000 B.C. in China. Other evidence shows rudimentary clay tablets in Babylon with carvings of sheep and grains on them, suggesting a basic type of promissory note obligating delivery of market produce to the bearer of the tablet.

The first standardized and documented use of these contracts goes back to 17th century Japan, where those who had stores of rice in their warehouses would sell receipts against the rice to raise cash. These “rice tickets” came to be used as an informal currency, changing hands dozens of times before the rice was actually claimed.

Throughout the 17th and 18th centuries, commodity exchanges popped up wherever trade and transportation were an issue: London, Amsterdam, Paris, and New York – with the granddaddy of them all, the Chicago Board of Trade, opening in 1848. It was there, nestled in the city that Carl Sandburg labeled the “hog butcher of the world,” that simple agricultural markets would go from the hands of farmers and merchants into the pockets of hedge fund managers and high-risk traders, and eventually into the plot of the movie Trading Places.

In the 1983 buddy movie, Eddie Murphy and Dan Akroyd use a dummied-up crop report to get the Duke brothers (exquisitely played by Ralph Bellamy and Don Ameche) to run up the price for frozen concentrated orange juice (FCOJ) futures. The Duke brothers wind up going broke on the gamble and Murphy and Akroyd make enough from the scheme to buy their own island.

Weather Investing: Money Between the Raindrops

These days, you can buy and sell contracts for wheat, milk, cattle, soybeans, pork bellies, lumber, and a dozen more subgroups of commodities. You can also trade futures on financial indexes like the Dow Jones Industrial Average, foreign currencies, and of course, weather events.

Simple temperature contracts cover temperature changes in 25 cities in the U.S. and Canada, and another dozen or so in Europe, Asia, and Australia. There are also contracts that cover frost, snow, rain, and hurricanes.

For the basic temperature contracts, a trader can pay a premium to another trader, the seller, for an option that lets him wager on future temperatures. If the temperature hits a specified level, the buyer collects an agreed-upon amount from the seller. If it doesn't, the seller keeps the premium and the contract expires. The whole thing is based on units called “degree days.” Temperatures are calculated daily from a baseline of 65 degrees Fahrenheit (18 degrees Celsius.) Each degree below 65 counts as one "heating degree day," the designation originally developed for utilities to calculate demand. A temperature of 50 degrees, for instance, counts as 15 HDDs. In summer, cooling degree days are calculated from the same 65-degree baseline.

You might ask what possible real-world application these contracts might have other than pure speculation. It turns out that in the right hands, these contracts can be quite useful. For example, in the United Kingdom, utility companies estimate that a one-degree temperature change causes a 5% swing in natural gas demand. If you’re a utility or a natural gas consumer of great quantity, you might want to purchase a hedge against the possibility of the run-up on the price of gas. Or, if you’re a huge consumer of oil refined in the Gulf of Mexico, then you’d be pretty interested in buying hurricane futures since large storms typically bring chaos to oil prices.

Also, if you own a ski resort or a golf course, the weather can make or break your business. An ordinary insurance company won’t sell you a policy based on rainfall, but you might be able to make some money on a rainfall investment to offset the loss you take when a downpour comes along and washes out the 15th fairway.

The Enron Corp. is responsible for selling the first weather derivative 10 years ago, agreeing to pay a utility $10,000 for each wintertime degree that was below normal. After a lull following Enron’s historic flameout, the weather trading market has taken off. Trading in weather contracts jumped 100-fold from 2003-2007, according to the Chicago Mercantile Exchange. This was due, in no small part, to hedge funds.

Some estimates put hedge fund speculation at over 50% of the $19 billion weather futures market. That means that instead of the farmers, oil rig operators, baseball stadium owners and other parties that have a direct relationship between their business and the weather, the majority of weather trading is done by speculators. This trend has been seen in almost every commodity market. Whether oil spikes or corn speculation, investors are taking over markets that were once the bailiwick of farmers and rural bankers. Or at least they were.

With the current economic downturn, futures trading volume was down 46% in 2008, with weather contracts down 54% as a group. With difficult times ahead, and the distinct possibility that exotic derivative products are partly to blame, many traders have gone back to basics.

And it’s no wonder. A recent study at Penn State pitted two distinct groups against each other in a weather trading simulation to see which would be more successful. According to the study’s press release, “the results so far show the market to be far more profitable for traders who are studying meteorology than those who are studying business.”