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Introduction to the Futures Market


The futures market is an integral part of the economic engine of any country. They serve a vital role in providing the producers and consumers a control over the future price of assets or commodities which they will sell or buy. The price of the goods or assets to be purchased in the future are decided in the present. Without them the market would still function however because of seasonal variations or international events, the price of the final goods can vary/fluctuate a great deal,  Sometimes fluctuations can dramatically affect the viability for businesses, producers, and consumers.

Within a futures market there are two basic types of participants.

  • One part is made of Hedgers. They are the producers or consumers of assets or commodities and by taking part in the futures market they want to ensure they get a particular price for their produce or they have to pay a given price for a commodity in the future. For example in the grain commodity, a farmer may want to make sure that their crop will reap a certain price in 3-6 months when they finally harvest it. This allows them to plan adequately for the amount of input cost to be used and the final price they will get. Another example of a hedger is the airline industry. A major part of the cost structure of an airline company is the fuel cost. Because of international events the price of oil can vary dramatically putting a strain on their operations and finally their balance sheets. In order to protect themselves from these variations they hedge their risk. They get into a futures contract to buy given quantity of fuel at a specified date in the future at a particular price. Therefore no matter what events occur they will still be able to obtain their requirement of fuel at a set price and hence they can plan their operations and pricing strategy accordingly.

  • The other division within a futures market is the Speculators. They do not have an inherent interest in the underlying commodity or asset but are looking to benefit from the movement of the market.

The first formal futures exchange came into being with the setting up of the Chicago Board of Trade (CBOT) in Chicago in the 1850s.   Before then, the use of similar concept was in place for centuries tracing back to Roman and Greek civilization. Here it was a kind of forward contract where two parties would decide in the present of a future price of a given commodity to be paid. This helped the buyers and sellers as it reduced the market swings in the price of the commodity. However as there was no official third party to guarantee every trade, all that futures market participants had to go on was trust. What ended up happening was that if the price of the commodity moved significantly from the future market price - it would give major incentive to one of the parties to renege on the contract.

Once formal futures exchanges were setup, the contract was instead with an exchange rather than directly with a counter party. If a seller was to sell 5000 bushels of wheat 6 months from now he would get the price according to the supply and demand of similar contracts. Once a buyer of a contract is found at a given price the seller trades the contract with the futures exchange to sell the wheat 6 months from now and at the same time the buyer makes the counter agreement to buy the wheat. This makes sure that both the parties will fulfill their obligations. The futures exchange uses a number of mechanisms like initial margin, maintenance margin, daily price limits, etc. to make sure the trades move transparently and credibly. These mechanisms also ensure that the future exchange itself does not suffer any loss due to non-payment by any party.   

Although the roots of most future exchanges lies in buying and selling of agricultural commodities or metals...more recently there has been a huge diversification in the type of commodities and financial assets which are available for trade.  Furthermore it's not just the type of assets which are traded but also the method has changed.  The primary method used to be an open outcry, where auctioning of the commodity was done in the pit or on the floor of the exchange. With the advent of internet and newer technologies most of the trading is currently done on an electronic platform. Some of the major exchanges like EUREX have completely moved to electronic trading showing the significance this medium has in current trading place.

Many people have questioned repeatedly over the use of futures exchange and if speculating within the market brings greater volatility in the prices of the underlying assets. Since the start of the first futures exchange there have been continuous legislative and other actions to put restrictions on the scope of the futures exchange. However most if not all the legislative actions have been repealed as the use of this medium stood the test of time in providing valuable service of providing sharing of risk, increased liquidity between traders and a credible system within which diverse parties can come and make use of the various options to suit their varied purpose.

There is a large amount of leverage which can be used in futures trading.  For example if you want to trade in gold, an underlying contract might be $100,000, but the amount of money (initial margin) you need to put up could be less than $5,000. This allows speculators a greater degree of profit margin. Example: If the value of gold increases to $101,000 the profit in the account would be $1,000 over an initial investment of $5,000. Hence instead of 1% profit the trader is able to get a profit of 20% on his investments. As long as you do not hit the margin requirements (ie. lose $5,000) the trade can continue.  If the trade goes the opposite direction, you might be forced to put up more margin ($$$) or be forced to sell your position at a loss.

NEXT: History of the Futures Market

Introduction to the Futures Market Tutorial

1) Introduction to the Futures Market
2) History of the Futures Market
3) How the Futures Market Works
4) Difference between a Forward and Futures Contract
5) Participants in the Futures Market
6) Main factors that impact Futures Prices
7) What is a Futures Clearing House?
8) Risks in the Futures Market

 

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