The futures market has a reputation for volatility that is only suitable for investors who have a high-risk tolerance. Compared to stocks and bonds, there is some truth in that assessment.
However, many people avoid it just because they do not have a solid understanding of many aspects of it. For instance, futures contracts in industries like soybeans, gold, crude oil, and many more started at or below ground level. The short-term and long-term performances of futures markets are indicators of how things affect consumers around the world, like how much gasoline would cost if you were planning to go on a road trip.
If you are interested in learning more about the futures markets and maybe in trading futures down the road, you have to lay out a foundation of knowledge. Let’s start with some basic questions.
What Is a Futures Contract?
A futures contract is a standardized legal agreement to sell or buy a specific commodity or asset on a predetermined date or a during a specified month in the future. Futures contracts are usually traded on electronic exchanges like CME Group, which is the biggest future exchange in the United States.
A “standardized” contract means it is effectively interchangeable. It contains specific details including:
– The asset’s price per unit and the minimum fluctuation in price, also called tick size
– The quantity and quality of the asset
– The date and place for the physical delivery of the asset. Note that in reality, actual delivery seldom occurs because most contracts are cashed out before the asset’s delivery date.
Here is an example. A corn futures contract with 4,000 bushels traded on CME Group in November 2017. The price was quoted in dollars per bushel, and a delivery date was specified in the contract. A futures contract in crude oil included 1,000 barrels of oil. The price was quoted in dollars and cents per barrel.
One of the best places to learn about the history of the futures market in the United States is at the website USA Futures.
Who Are the Traders in Futures Contracts, and What Are Their Reasons for Trading?
Traders in futures come from all backgrounds. The market is quite active. The robust activity from all brings high liquidity to the market. This makes the trading and business environment easier for everyone involved.
The original traders are producers and processors of commodities. Think of oil, precious metals, and grain. Then came the speculators like large banks, hedge funds, and retail and individual traders whose livelihood is trading in futures.
Players in the futures market have their reasons for trading. A grain processor who expects an exceptionally dry summer in the Midwest farm states might want to trade as a hedge against potential price increases in certain agricultural commodities.
Speculators might want to make a quick profit by buying low and selling high. Taking advantage of the futures contract price fluctuations is similar to timing the equities markets. Speculators monitor how the price moves, then take action at the opportune time to realize a profit.
Commercial traders and speculators are key components in keeping the futures markets liquid. The high number of eager sellers and buyers keeps the markets active. This is not much different from the equities and bond markets.
What Is the History and Evolution of Futures?
The first futures contracts can be traced back to the early 17th-century rice markets in Japan. However, the futures trading that the West is familiar with started around 1852 when the Chicago Board of Trade (CBOT) was created by a group of grain merchants.
Shortly after CBOT was formed, they created the first documented “forward” contract for 2,000 bushels of corn. This laid the groundwork for the current futures contract. Over the past 10 years, CBOT and other exchanges were acquired by CME Group.
Why did Chicago become the birthplace of futures contracts? The reason is due to the city’s geographic location. It is right in the center of the country’s agricultural industry. So, it was a convenient location for sellers and buyers to meet and trade.
Farmers would take to the market their livestock and crops that they had grown and raised to sell them to commercial buyers.
There were many risks for both the buyers and sellers. Buyers risk receiving products that are below standard. If the past growing season was poor, they might not get any product at all if not enough was produced.
Buyers needed an assurance that the quality and quantity of a commodity they want would be available when they require it. Sellers, typically farmers, need an assurance that there are buyers for their massive amounts of crops, or else they would be out of business.
Categories of Futures Orders
At the center of futures trading order. So, to make good trade decisions, it is important to understand the different types of orders.
Market Order: This is a basic type of order with instructions for the broker on buying and selling at the best price available. Market orders execute almost right away, and they are considered the quickest method of getting in or out of a trade.
Limit Order: This is an order with instructions to sell or buy a futures contract at a certain price or better. There is no guarantee that a limit order will be filled. It lets the trader set a price so they do not suffer any price slippage.
Stop Market Order: This order executes a market order when a set price, called the stop price, is reached. When the stop price is reached, the stop market order turns into a market order and will execute at the best price.
Stop Limit Order: This is like a stop market order with the exception that when the stop price is reached, a limit order is executed. It still does not guarantee that it will be filled, but it does give you more control of the price range where the order will execute.
What Are Futures Roll Dates?
Futures contracts do expire. They are active only for a certain amount of time. Throughout the year, each futures market has its sequence of events as the contract expires. Before expiration, traders can choose to exit their active position or roll their contract over to a later date. This essentially extends the contract’s expiration period.
Futures contracts also must result in one of the following: either the asset is physically delivered to the buyer, or the contract is cashed-out. When it is settled by cash, a credit or debit is issued. For physically delivered contracts, the trader must produce or take delivery of the commodity when the contract expires. Although this is an option for traders, most of the time, traders close or roll over their positions to avoid futures delivery.