Futures Trading -- The Basics
Futures trading is all about trading Futures Contracts. What is a Futures Contract? A Futures Contract, also known as a "Forward" Contract (or cash forward sale) is a contract between a seller who supplies a commodity at a given date for an agreed upon market price to a buyer. This is a formal obligation. Money does not change hands until the date of delivery. Futures Trading is considered to be a "Zero Sum Game", that is, for every dollar made, that same dollar is lost by someone else. If prices are too high or too low, either the buyer or the seller profits, but at the expense of the other. For example, if wheat prices go up, the farmers benefit but the bread manufacturer suffers. If wheat prices go down, the farmer suffers, but the bread manufacturer benefits.
Futures trading occurs on the floor of an exchange, such as the Chicago Mercantile Exchange (CME), where actual trading takes place in the open outcry pit. Futures trading also can take place "electronically," over the internet from desktop platforms, with customers submitting their buy or sell orders.
Futures traders are basically divided into two groups: hedgers and speculators. The group, hedgers, are primarily farmers, manufacturers, or exporters. Hedgers create futures positions so they can reduce their risk in case the price of their commodity falls. For example, a wheat farmer plants a crop to be harvested in September. He goes to the CME and actually sells wheat futures contracts for his entire crop, but in June before the harvest. He sells at the current market price with a contract delivery date in September. In June there may not be much wheat available, so the price of wheat is high. In this way, should the price of wheat fall in September because of a bumper crop, he has already protected his crop with the June price. Of course, the farmer is taking a risk. It may be that there is no bumper crop in September and the price of wheat rises even further and he only gets the contracted June price.
Speculators, unlike hedgers, trade Futures for the sole purpose of earning a profit; they do not have a commodity to protect. Speculators make up the majority of traders in most markets. Speculators assume risk in the hope of buying low and selling high (going long), or of selling high and later buying back low (going short). Speculators provide the liquidity needed in the Futures market. Without speculators, there would be no trader available to take the other side of the hedgers contract. Take the example above, the farmer sells the wheat to the speculator in June for the current market price. The speculator is assuming risk. He expects that by September, the contract delivery date, the price of wheat has gone up and he can make a profit at the farmer's expense. The risk he takes, and hopes doesn't happen, is that in September, the price of wheat has gone down and he over paid.
Before organized Futures exchanges like the CME, Futures trading was far more risky. Contracts between a farmer and a speculator were signed where the farmer happened to be selling his produce, like a farmers markets. There were significant problems with individual contracts. Either the farmer or the speculator could default on the contract. If the speculator thought he was going to lose money, he would not pay for the contract he negotiated. If the farmer thought he was going to lose money, he would sell his crops to someone else for a higher price. Moreover, there was no one who would certify the delivery. The farmer could deliver inedible product.
With the coming of organized exchanges, it was now the responsibility of the exchange to certify delivery and ensure payment. Exchanges required good-faith money to be deposited with a third party to safeguard contract performance, dramatically reducing contract defaults. Exchanges also standardized contracts, stipulating contract terms, such as commodity grade and delivery dates.
In recent years, futures trading evolved beyond buying and selling commodity contracts. Today, futures contracts are available across a variety of asset classes, including equities, currencies, metals and energies. Futures are known as "derivatives." A security whose price is derived from one or more underlying assets is a Future. For example, the S&P500 Futures Contract is based upon the underlying asset -- the S&P500 Index traded on the NYSE. The S&P500 Index is one of the most heavily monitored stock indexes throughout the world. The index is a combination of the top 500 stocks traded on the New York Stock Exchange (NYSE). The stocks that constitute the S&P500 are the most well recognized companies. However, you cannot trade an Index. The CME created an S&P500 Futures Contract that you can trade. In the case of the S&P500 Futures Contract, when the value of the S&P500 Index goes up, the S&P500 Futures Contract goes up along with it and vice versa.
Along with equity stock indexes, Futures can also be based upon currency movements. For individuals, currency trading is tailored to the small number of contracts that small investors tend to trade. With Currency Futures, individual investors can trade the same currencies that are traded in the Forex market, but trade on the CME.
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