In this segment, we’re going to talk about the basics of the futures market how the market evolved, the concept of a futures contract, and market mechanics.
The Futures Contracts
Basically, a futures contract is an agreement to make, or, take a delivery of a commodity or financial instrument at a fixed date in you guessed it the future. So, even though the delivery isn’t going to happen until a later date, the price of the transaction is determined to right now, in the open market.
Now, the idea of futures trading is nothing new. It actually started around 150 years ago as a way to manage agricultural production. The problem was that planting and harvesting cycles created huge swings in prices, so you had these ongoing boom and bust crises. You have to remember, back then they didn’t have the physical and business infrastructures that we do today. Storage, transportation, insurance, lending none of that was very advanced. Just wasn’t around yet. That is where futures contracts came in.
They offered the producers and the users of these agricultural goods a way to buy and sell goods on the spot and then defer delivery date. Farmers could sell crops before the harvest, and deliver them afterward. The bottom line is that trading futures had the exact effect the risk managers of the day, hoped that they would.
Pricing goods and financial instruments in an open market along with public dissemination of those prices allowed businesses to transact and plan with greater efficiency. The same principle applies today. Of course, as time went on and people kept trading and becoming more familiar with futures, the whole process became more efficient.
Trading and pricing became easier because each contract within an exchange’s markets is identical to all the other contracts in that market on that exchange. So what are some of the terms you need to know if you’re going to trade futures? That is Quantity.
Each contract represents a fixed and standard weight or measure. For example, in the Wheat Futures market, a standard contract is 5,000 bushels of wheat. Or in Crude Oil, the benchmark contract is 1,000 barrels.
Delivery and Payment Terms
This describes where and when delivery will be taken, and under what payment terms. For example, in the case of Gold, there are delivery terms that specify the metal’s weight and purity. In plain English, the buyers and sellers indicate that they accept these terms by trading the contract.
Futures contracts are exchange-traded instruments with no concept of over-the-counter or ECN transactions. The contract terms are formulated by the exchange and then offered for trading on that same exchange. So even though different exchanges may list certain contracts for the same commodity, the important thing to remember is that every exchange’s contract is going to be different.
Now, just because you buy a futures contract, that doesn’t mean you’ll ever see delivery on what you purchased. In fact, relatively few futures contracts result in delivery or cash settlement. That is because most futures are offset in the open market before they have a chance to mature. But if you are interested in risk management, this allows you to add and remove futures positions at will.