Futures trading is one of the most difficult concepts for novice investors to comprehend. To better understand the present of futures, it’s best to look back into the past.
Back to the Futures Part I – The Origins of Futures Trading
Futures has its roots in forward contracts. Although forward contracts date back to the Middle Ages, they became most popular in 18th and 19th century America. Way back then, farmers from across the American mid-west used to bring their grain to Chicago with each harvest.
Since there was a surplus of grain available at that one time, the stockyards were able to bid down the price paid to farmers. Then later in the year, as supplies dwindled, the stockyards would sell grain at a healthy premium.
Understandably, the farmers thought that this was unfair. Grain consumers also thought it was unfair. In the modern age, farmers and large grain purchasers can engage in futures trading in order to hedge their risks, but back then, there was no such thing as futures.
Instead, farmers and large consumers established forward contracts. In these arrangements, farmers would agree to supply a grain purchaser with an agreed-upon amount of grain at an agreed-upon price, and at an agreed-upon date and location – thus, eliminating the middleman.
Back to the Futures Part II – Why Futures Trading is Necessary
So why do we need futures when forward contracts seem to solve the problem? Well, while forward contracts solve some problems for farmers and consumers, they create new ones. First of all, there was no guaranteed way of enforcing the forward contracts.
Secondly, the market wasn’t very fluid. Prices could go up and down for little or no reason, and buyers and sellers had a hard time finding one another. Futures trading eliminates these problems.
For one, futures establishes standardized contracts. On the Chicago Board of Trade, for example, a futures trading corn contract is standardized to 5,000 bushels of U.S. No. 2 yellow corn, with delivery dates of either March, May, July, September, or December.
If a farmer wants to guarantee his price for corn, he can sell a futures contract today, and make delivery on the date specified in the contract.
Back to the Futures Part III – Futures Trading for Hedging or Speculating
In reality, few futures contracts are ever “delivered.” This means that a farmer who sells a May corn futures trading contract is unlikely to eventually deliver 5,000 bushels of No. 2 yellow corn to the Chicago Board of Trade, and the investor who buys the futures contract is unlikely to actually take possession of the corn.
Instead, people involved in futures trading typically “close out” their positions before they take delivery. For example, the farmer would most likely later buy a May contract, and the investor would most likely later sell one.
In the above case, the farmer would be using futures as a “hedge.” After all, the farmer may live hundreds of miles from Chicago, and delivery would be impractical if not impossible. In all likelihood, the farmer would sell his actual corn at a local market. His futures trading would be just to guarantee a given price.
For example, if the current price of corn were $2.40 per bushel, but the farmer feared it might drop, he could engage in futures to hedge by selling a later delivery of one contract (5,000 bushels) at $2.40 per bushel. Then, as the delivery date of the contract came near, he could buy an offsetting contract, thereby closing out his position.
If the price of corn went up, the farmer would lose money on his futures trading. If the price of corn went down, he would turn a profit, but either way, he would be hedged.
On the other hand, there are speculators. These investors aren’t participating in futures in order to hedge; they’re simply trying to make a profit. The good thing about speculators is that they help make markets more liquid.
This means that there is less volatility, and prices remain more accurate. For example, if the price of corn fell too low, speculators would come in and buy contracts in order to push the price back up. If the price of corn skyrocketed due to a short-lived panic, speculators would begin selling contracts and thus, driving the price down.
Speculators get a bad name in the mainstream media, but that’s because most newsmen and women don’t understand how financial markets work. If you’re a speculator engaged in futures trading, pat yourself on the back for doing our country and the world a great service.