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FUTURES HISTORY
In the 1840s, Chicago had become a commercial center with railroad and telegraph lines connecting it with the East. Around this same time, the McCormick reaper was invented which eventually lead to higher wheat production. Midwest farmers came to Chicago to sell their wheat to dealers who, in turn, shipped it all over the country.
He brought his wheat to Chicago hoping to sell it at a good price. The city had few storage facilities and no established procedures either for weighing the grain or for grading it. In short, the farmer was often at the mercy of the dealer.
1848 saw the opening of a central place where farmers and dealers could meet to deal in "spot" grain - that is, to exchange cash for immediate delivery of wheat.
The futures contract, as we know it today, evolved as farmers (sellers) and dealers (buyers) began to commit to future exchanges of grain for cash. For instance, the farmer would agree with the dealer on a price to deliver to him 5,000 bushels of wheat at the end of June. The bargain suited both parties. The farmer knew how much he would be paid for his wheat, and the dealer knew his costs in advance. The two parties may have exchanged a written contract to this effect and even a small amount of money representing a "guarantee."
Such contracts became common and were even used as collateral for bank loans. They also began to change hands before the delivery date. If the dealer decided he didn't want the wheat, he would sell the contract to someone who did. Or, the farmer who didn't want to deliver his wheat might pass his obligation on to another farmer The price would go up and down depending on what was happening in the wheat market. If bad weather had come, the people who had contracted to sell wheat would hold more valuable contracts because the supply would be lower; if the harvest were bigger than expected, the seller's contract would become less valuable. It wasn't long before people who had no intention of ever buying or selling wheat began trading the contracts. They were speculators, hoping to buy low and sell high or sell high and buy low.
WHAT IS TRADED
It has to be standardized and, for agricultural and industrial commodities, must be in a basic, raw, unprocessed state. There are futures contracts on wheat, but not on flour. Wheat is wheat (although different types of wheat have different futures contracts). The miller who needs a wheat futures to help him avoid losing money on his flour transactions with customers wouldn't need a flour futures. A given amount of wheat yields a given amount of flour and the cost of converting wheat to flour is fairly fixed. hence predictable. Perishable commodities must have an adequate shelf life, because delivery on a futures contract is deferred.
The cash commodity's price must fluctuate enough to create uncertainty, which means both risk and potential profit.
FUTURES EXCHANGE
Most exchange trading floors are divided into pits (or rings) where traders stand facing one another. These are more or less shallow octagonal areas with raised steps around the edge. Each pit is designated for trading one or more futures contracts. For instance, at the Chicago Board of Trade (CBOT) there are large pits for trading T-bonds, soybean, and corn futures among many others. The Commodities Exchange Center in New York houses more than one futures exchange. There you will find trading pits for such diverse commodities as coffee, sugar frozen orange juice, cocoa, gold, cotton, and heating oil.
Every futures exchange is set up in about the same way. Like the stock exchanges, the people trading on the floor must be members of the exchange itself. The members support the exchange by dues and assessments. Non-members - average investors, for instance trade through brokerage firms whose officers or partners hold memberships.
The exchange provides the place to trade and support facilities, such as phones and price-reporting and dissemination systems. It does not set prices or buy or sell for itself. However, its employees scrutinize operations and strictly enforce exchange rules and federal commodity trading regulations.
FUTURES CONTRACT
Unlike a stock, which represents equity in a company and can be held for a long time, if not indefinitely, futures contracts have finite lives. They are primarily used for hedging commodity price-fluctuation risks or for taking advantage of price movements, rather than for the buying or selling of the actual cash commodity. The word "contract" is used because a futures contract requires delivery of the commodity in a stated month in the future unless the contract is liquidated before it expires.
The buyer of the futures contract (the party with a long position) agrees on a fixed purchase price to buy the underlying commodity (wheat, gold or T-bills, for example) from the seller at the expiration of the contract. The seller of the futures contract (the party with a short position) agrees to sell the underlying commodity to the buyer at expiration at the fixed sales price. As time passes, the contract's price changes relative to the fixed price at which the trade was initiated. This creates profits or losses for the trader.
In most cases, delivery never takes place. Instead, both the buyer and the seller, acting independently of each other, usually liquidate their long and short positions before the contract expires; the buyer sells futures and the seller buys futures.
Arbitrageurs in the futures markets are constantly watching the relationship between cash and futures in order to exploit such mispricing. If. for example, an arbitrageur realized that gold futures in a certain month were overpriced in relation to the cash gold market and/or interest rates, he would immediately sell those contracts knowing that he could lock in a risk-free profit. Traders on the floor of the exchange would notice the heavy selling activity and react by quickly pushing down the futures price, thus bringing it back into line with the cash market. For this reason, such opportunities are rare and fleeting. Most arbitrage strategies are carried out by traders from large dealer firms. They monitor prices in the cash and futures markets from "upstairs" where they have electronic screens and direct phone lines to place orders on the exchange floor.
WHY FUTURES PRICES CHANGE
The cost of carry explains the basic relationship of cash to futures pricing, but it does not explain many less certain factors that can affect futures pricing such as seasonal influences and other unpredictable events.
As for Interest-rate and currency futures - those based on T-bonds, T-bills, Eurodollars and the five major currencies - the biggest influences are the policies and trading activities of the Federal Reserve, U.S. Treasury and foreign central banks, all of which affect interest rates.
Stock indexes are affected by whatever influences the stock market as a whole. Interest rates certainly play a major role - higher interest rates usually hurt the stock market. Other effects include the overall prospects for corporate earnings and corporate tax policies that help or hurt big business.
Futures trading provides a way to establish a form of price knowledge leading to continuous price discovery. Futures prices reflect not only current cash prices, but also expectations of future prices and general economic factors.
Disclaimer - I am not a commodity trading advisor. The information on this site is for trading education only. There are no trading recommendations for any one individual made on this site and this information is paper trades for trading education. All trades are extemely risky and only risk capital should be used when trading.
U.S. Government Required Disclaimer - Commodity Futures Trading Commission Futures and Options trading has large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don't trade with money you can't afford to lose. This is neither a solicitation nor an offer to Buy/Sell futures or options. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this web site. The past performance of any trading system or methodology is not necessarily indicative of future results.
CFTC RULE 4.41 - HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.