How futures are traded

To better understand how futures are traded, it is helpful to know what a future is, the history behind them, and the benefits of trading them in addition to the trading process. A 'future' is an evolved financial contract to buy or sell an underlying commodity or product at a future time. Futures are exchanged through authorized clearinghouses such as the Chicago Board of Trade and must be exercised on a predetermined date called the 'final settlement date'.

The exchange of futures contracts is regulated by the Commodity Futures Trading Commission and requires the use of credit to the contract purchaser and has less risk than a similar contract called a forward. Since futures contracts and prices are derived from a product or commodity they all called derivative securities. Speculators often buy and sell these contracts with the intent of making a profit off price fluctuations before the delivery date, however they are also used to by farmers and agriculturalists to hedge farm operating costs, and product sale prices such as those associated with animal feed and grain prices.

The history of futures

Modern day futures trading evolved out of a forward trading system which was used in the mid 1800's as a way for farmers, bankers and merchants to collaborate their interests financially. A forward contract is an agreement between two or more parties to deliver a specific product on a specific date in the future. These contracts are different from futures in that they don't have to be traded using an exchange and the settlement of price is determined by delivery of the product rather than the final settlement date.

One of the largest exchanges through which this process took place was the Chicago Board of Trade, which was called The Board of Trade of the City of Chicago in the 1840's. Over the following 30 years after 1840, futures trading which occurred through the exchanges became more regulated and standardized allowing the futures exchange to become more reliable and standardized. Eventually, in the 1970's a fixed market related to, but separate from the actual underlying commodities emerged in which financial instruments such as bonds and foreign currency could also be traded using futures contracts.

The trading process

Futures are traded using 'margin' which is a financial term for a credit account with a minimum down-payment or collateral. This margin amount is usually between 5-15% but may go much higher. A speculator or trader buys a futures contract through an exchange and/or a broker who works through the exchange and does so at a fixed cost of the underlying security. If the price of the underlying commodity or financial instrument rises during the term of the futures contract, the contract holder can make a profit.

Despite this, if the price falls, a loss will be incurred. During each day the buyer of the futures contract continues to hold it, the profit or loss is recalculated. Speculators in futures trading sometimes use a trading strategy using technical indicators and other financial tools to aid them in their decision making. A step by step process of trading futures is as follows:

1. Use a reliable brokerage account that works through an exchange that trades futures.
2. Choose a commodity or financial instrument to trade in such as coffee or currency.
3. Study the different contracts, the costs and goods.
4. Develop a trading strategy
5. Purchase the Futures contract and hope steps 1-4 work.

Why Futures are Useful

Futures contracts are useful because their derivative nature affords them the ability to represent advanced securities transactions, products and financial instruments through a systematized trading environment. In other words, they greatly facilitate commercial trade. Some of the ways they do this are as follows:

• Control price risk fluctuations by locking into a fixed price
• Assist companies in generating capital in advance of sale.
• Demonstrate buyer and seller predictions of future prices.
• Assists observers with assessing economic and market conditions through price efficiency theory.
• Can be used across many markets including currency, bond, equity index and commodities markets.

Who Invests in Futures and Why

Futures are traded by farmers, agriculturalists, financial institutions and speculators. While all have a financial interest in the contract, they may have different reasons for entering into the contract. In the case of 'hedging' for risk , farm managers and crop farmers attempt to bring a more stable cost and selling environment to their operations through locking into a futures contract price they think is fair. For speculators and financial institutions however, the purpose of the contract is different. For these latter two participants, the intent is profit. These latter two generally do not intend to exchange the underlying commodities but rather the money for them and hopefully at a profit. Since the clearinghouse assumes the cost of the commodities they take responsibility for the cost of the commodities and can re-sell the contract.

Summary

Futures contracts are financial agreements to buy or sell an underlying commodity at a fixed price on a settlement date. While the actual commodity need not be exchanged, this does happen as the futures market has evolved out of an actual commodities exchange system. The currently futures market is currently very sophisticated, and takes place through traditional trading and electronic exchanges that are regulated by Commodity Futures Trading Commission (CFTC). 

Futures contracts have the potential to be costly especially if the price of the commodity drops rapidly within a short time period. However, the contract may also be profitable if exercised at a profit. Futures contracts have a history in the commodities trade of farm products but have expanded to include metals, energy resources and financial instruments such as currency and bonds.

Sources:

1. Zvi Bodie, Alex Kane and Alan J. Marcus. 'Investments' New York. 2002 McGraw-Hill Irwin. p.739-760.
2. http://www.answers.com/topic/futures-contract?cat=biz-fin
3. http://eh.net/encyclopedia/article/Santos.futures
4. http://www.riskglossary.com/link/future.htm
5. http://en.wikipedia.org/wiki/Futures_contract
6. http://www.cftc.gov/