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Futures Market Explained

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Futures Market Explained

Futures Market is a complex place where commodities such as oil, corn, coffee, cotton, and precious metals among many others are bought and sold. It is a financial contract obligating the buyer or the seller to buy/sell the commodity or a financial intrument by a predetermined future price and date.

These contracts mature at a particular point in the future and are identified for that date – for instance, a July 2008 corn futures contract or a December 2008 S&P stock index futures contract. The ability to make or take delivery of the underlying commodity at expiration creates a strong tendency for cash and futures prices to move in the same direction by roughly equal amounts.
Futures Trading Basics

Futures trades take place at any of a number of centralized exchanges, often in open outcry, auction style trading pits, but electronic trading platforms such as the Chicago Mercantile Exchange’s Globex system, for example are growing. In every transaction, the exchange clearinghouse is substituted as the buyers to the seller and the seller to the buyer, thereby guaranteeing performance and eliminating counterparty risk. Customers who trade futures are required to post margin deposits with an exchange member firm which, in turn, must deposit the margin with the exchange. Margins are not payment against the market value of the commodity represented by the futures contract, but rather are a performance bond – a good faith deposit to ensure the ability of market participants of their financial commitments and cover any obligations which might arise out of their trading activities.

Buying a futures contact is called taking a “long” position. Selling a futures contract is referred to as taking a “short” position. A long futures position profits when the futures price goes up, and a short futures position profits when the futures price goes down. Maturing futures contracts expire on specific dates, usually during the contract month. At any time before the contract matures, the trader may offset, or close out, his or her obligation by selling what was previously bought, or buying what was previously sold. By offsetting an open futures contract, a trader is relieved of any obligation to make or take delivery of the underlying commodity or financial instrument. This is made possible by the fact that futures contracts have standardized terms and trade on centralized exchanges. The vast majority of futures contracts, are closed out by offsetting market transactions prior to their maturity, rather than through the delivery process.

Futures Exchanges, Clearing houses and Market Professionals

US futures exchanges typically operate with a trading floor where traders and brokers compete on equal footing in an auction-style, open-outcry market and where they communicate by voice and hand signals with others in the pit. Customer orders coming into the futures pit is delivered to floor brokers who execute them with other floor brokers representing other public customers or with floor traders known as locals trading for their own accounts.

Trading by means of other electronic order matching has been slower to catch on in the US than in most other countries. The pace of implementation of such technology has accelerated recently, however the electronic trading is becoming more and more commonplace, though futures trading in the US continues to be dominated by the open-outcry, auction style pit trading during normal business hours.

Traditionally, each US futures exchange has had its own clearinghouse that acts as the bookkeeper and settlement agent. In every matched transaction executed through the exchange’ facilities, the clearinghouse deals exclusively with clearing members and holds each clearing member responsible for every position it carries on its books, regardless of whether the position is being carried for the account of a non-member public customer or for the clearing member’s own account. The clearinghouse doesn’t look to public customers for performance or attempt to evaluate their credit worthiness or market qualifications. Instead, the clearinghouse looks solely to the clearing member carrying the guaranteeing the account to secure all margin requirements and payments. The clearinghouse system is an important aspect of the financial integrity of the futures market.

A futures brokerage firm, known in the US as the Futures Commission Merchant (FCM), is the intermediary between public customers and exchange. An FCM may be a full service firm or a discount firm. Some FCMs are part of a nation or regional brokerage companies that also offer securities and other financial services, while other FCMs offer only futures and futures options. In addition, some FCMs have as a parent or are related to a commercial bank, Agribusiness Company or other commercial enterprise. An FCM maintains records of each customer’s open futures and futures options positions, margin deposits, money balances and completed transactions. In return for providing these services and for guaranteeing the account carried on its book to the exchange clearinghouse – an FCM earn commissions. By US law, an FCM is the only entity, outside a futures clearinghouse that can hold the funds of futures customers.

Federal law also requires an FCM to segregate customer funds from the firm’s own funds at all times. The funds in segregation must be sufficient to meet the firm’s obligations to customers, and the FCM may not use those funds to satisfy any of its own obligations to creditors. Furthermore, an FCM may not use those funds to satisfy its own obligations to creditors. An FCM must deposit its own funds to cover any customer account deficits until the customer remits sufficient funds. Segregation of funds is designed to protect customer funds and make it possible to identity such funds in the event of an FCM’s default or bankruptcy.

Trading Participants: Hedgers and Speculators

Futures market participants may be divided into two broad categories: Hedgers, who actually deal in the underlying commodity or financial instruments and seek to protect themselves against adverse price fluctuations, and speculators (including professional floor traders), who seek to profit from price swings.

The futures markets exist to facilitate the management of risk and are thus used extensively by hedgers, individuals or businesses that have exposure to the price of an agricultural commodity, or currency, or interest rates, for instance, and take futures positions designed to mitigate their risks. This requires the hedger to take a futures position opposite to that of his or her position in the actual commodity or financial instrument. For example, a soybean farmer is at risk should the price of the commodity fall before he harvests and sells his crop. A short position in the futures market will return a profit when the price of soybeans declines, and the hedger’s profit on the short futures position compensates for the loss on the physical commodity.

Speculators are attracted to futures trading purely and simply because they see the opportunity to profit from price swings in commodities and financial instruments. Speculators take advantage of the fact that the futures markets offer them access to price movements; the ability to offset their obligations prior to delivery; high leverage (low margin requirements); low transaction cost; and ease of assuming short as well as long positions (short futures positions, unlike short stock positions, are not subject to any up tick rule nor to any broker/dealer interest charges). In pursuit of trading profits, speculators willingly take risks that hedgers wish to transfer. In this process, speculators provide the liquidity that assures low transactions costs and reliable price discovery, market characteristics which, in turn, make futures market attractive to hedgers.

Regulation of the Markets

The Commodity Futures Trading Commission (CFTC) is the federal agency that regulates the futures markets. The mission of the CFTC, which was created by Congress in 1974, is to protect futures market participants against manipulations, abusive trade practices and fraud; to guarantee the integrity of futures market pricing; and to assure the financial solvency of futures brokerage firms, exchanges and clearinghouses. The CFTC’s oversight and regulation help assure that futures markets provide effective price discovery.

Investing in Commodities

Here you will find a better way of investing immediately in order to participate in this lucrative market. We will get into further detail with futures in the next few months. Please be careful, you can lose alot of money if you do not know what you’re doing. One key rule to wealth is to prepare you mind and don’t go in blind. This is a very dangerous way to lose your shirt if you don’t know what you’re doing.

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