How Futures Trading Works

Table of Contents
Chapter 1: What is Futures Trading
Chapter 2: How Futures Trading Works
Chapter 3: Futures Terminology
Chapter 4: Importance of Futures Market
Chapter 5: Limitations on Futures Trading
Chapter 6: Factors Affecting Futures
Chapter 7: Who Should Use Futures Trading
Chapter 8: How to Start Trading in Futures and Be Successful

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Chapter 2: How Futures Trading Works
The Participants
Why Participants are Attracted to Futures Contracts
How Futures Came into Being

Chapter 2: How Futures Trading Works

A futures trade is a simple deal between two parties to be carried out at a future date. One party requires the asset and the other wants to sell it at that date. Various buyers and sellers of different kinds of commodities, securities, and even currency, are brought together in the futures market. Here they find suitable opposite parties and strike a deal.

Futures trading is done in an exchange, in a way similar to stock trading. The Chicago Mercantile Exchange is a prominent exchange where futures trading can be carried out.

Futures exchanges typically have separate areas for each commodity being traded so that buyers and sellers can match their requirements easily. A system of calls lets the members of the exchange participate physically in the trading by calling out bids on the floor of the exchange.

Traders who are not members cannot bid or offer their goods directly in the stock exchange. They have to route their futures trade through a broker who is a member of the exchange. The futures market is a highly organized one and the constantly changing prices are listed electronically to facilitate trading.

A typical futures contract has a specific date when the transaction is to be carried out, the terms at which the deal will be completed and the commodity which is to be traded.

The Participants

When a seller fears that the value of the assets he is holding or is about to take possession of may decline in value by the time he is ready to sell, he enters into a futures contract. He finds a buyer who needs these same goods at the time in future when they will be ready to use. The prospective buyer and future seller fix a mutually agreed price at which the commodity will be sold and a date on which the transaction will be executed.

A buyer may enter into a futures contract to freeze the cost of raw material used in production so that the final product price remains stable. He will agree to a futures contract for the commodity at a price which he believes is lower than his expected price when the contract expires.

When the date of transaction comes, the deal is either executed or the difference in price is paid to whichever party has gained in the transaction.

A farmer enters into a futures contract for selling coffee beans to Starbucks. He agrees to sell 100 lbs of coffee in September 2010 at a price of $1 per lb. On the date of the transaction, let’s say, the price of coffee per lb is $2. Now the farmer must still sell at his agreed future sale price of $1 x 100 lbs = $100 to Starbucks, although he could have sold at $200 if he had traded the coffee in the open market.

Starbucks is insulated from the rise in price because the purchase price has been frozen at $1 per lb. Similarly, if price of coffee had fallen, the farmer would have benefitted from the futures contract at the expense of Starbucks.

These days, the offset of losses or credit of gains to the two parties in a futures contract takes place on a daily basis. Once the contract has been entered into, the price fluctuations in the commodity affect the position of both the seller and buyer at the end of every trading day. The trading accounts of the parties are updated with the effects of the price movement.

On a day when the price of coffee has risen by $0.50, the farmer’s account will be debited $50 ($0.50 x 100 lbs) and Starbucks’ account will be credited with $50. These debits and credits continue until the date of expiry of the futures contract.

This daily settlement minimizes the risk of default by either party. As the accounts of both parties need to have a minimum amount after offsetting any losses, the gaining party is almost always guaranteed that it will receive its profits.

Why Participants are Attracted to Futures Contracts

In the example, Starbucks enters into the contract to make sure that it can procure basic raw material for its coffee at a reasonable rate. It cannot hike the price of its products to match higher coffee costs in September only to bring it back down the next month if coffee prices decline. The coffee maker needs to have stable prices for the finished products.

In this deal, Starbucks gained $100 in its futures account. The farmer is not actually required to deliver the 100 lbs of coffee to Starbucks. The coffee maker can simply purchase the 100 lbs from the market at $2 per lb, pay $200 for the new transaction and set off the $100 gains from the futures contract against this expense. The net expenditure is still $100. Starbucks in this way has protected its raw material costs against the price increase.

Sellers also benefit from futures trades although the farmer in this example ended up selling at a lower price than he could have in the market. He can sell the 100 lbs of coffee at $2 in the market, but he has to pay $100 to Starbucks against his loss in the futures contract.

However, because of the futures contract, he gets to know beforehand how much coffee he can sell at the end of his harvest and at what price. This allows him to plan his coffee planting in advance, so that he produces just what he can sell.

The two parties almost always do the actual buying and selling of the commodity in the open market when they have a need for raw material. They use the futures account simply to cover the price changes. But in some cases, the actual delivery may also take place at the end of the futures contract.

The futures market plays a critical role in letting manufacturers assess their future demand. A commodity with a long shelf life may not pose much of a problem even if the demand is miscalculated leaving the seller with much of his produce unsold. But this can lead to huge losses with perishable commodities.

How Futures Came into Being

Back in the 1840s, wheat production was increased significantly by the invention of the efficient McCormick reaping machines. Chicago was then a trading hub where wheat was sold by farmers to dealers. However, it was very difficult to store wheat there for long periods if the produce remained unsold.

This left the farmers with little choice but to sell at significantly lower prices if the supply was in excess of what was in demand. With the increase in supply because of the easier production processes, this problem occurred quite frequently.

The establishment of centralized trading arenas brought farmers and buyers together. Farmers began to enter into contracts for future supply of wheat so that the demand and price for their produce was assured. These were the precursors of today’s futures contracts.

Both traders and manufacturers sold the future contract to other parties if they could not or did not wish to fulfill the obligations. This led to a huge market for trading futures contracts. Over time, these contracts began to be adapted to other commodities, securities and even currency.

Next Chapter: Futures Terminology