What Are Futures? A futures contract is a standardized agreement between two parties to buy or sell a security or commodity at a future date and price. The futures contract is standardized, it is non-optional, and is traded on an exchange.
A Brief History of Futures Contracts
Futures trading in the US began in the 1800s, when grain farmers would sell their produce either directly for cash, or for forward delivery at a future date, on centralized grain markets. These agreements for forward delivery acted as private contracts between the buyers and sellers, with unique terms of settlement, and were the antecedents of the modern day futures contract.
The introduction of standardized terms for quality, quantity, and the place and time of delivery gave birth to the futures contract, which is traded on an exchange such as the Chicago Mercantile Exchange. The exchange facilitates trading and also acts as a mediator and guarantor.
The buyer of a contract, who will profit if prices increase, is said to be “long”, while the seller who profits from a decline in prices is said to be “short”.
Futures Price Discovery
The price of a futures contract is affected by the same factors that affect the value of the underlying commodity, and the trading price of the contract is discovered through an auction-like process in which buyers and sellers can bid the price both up and down. Because the price of futures are determined by the value of another asset, futures contracts are considered a ‘derivative’ product, meaning that their price is determined by that of the underlying asset.
Range of Futures Markets
Though the futures markets began with traditional agricultural commodities such as livestock and grains, a market in natural resources such as crude oil and precious metals soon developed, and by the early nineteen-seventies futures were created for equity indexes, interest rate products, and currencies. Trading initially in “pits” on the floor of the exchanges, the majority of volume in these markets now transacts electronically through platforms such as the Chicago Mercantile Exchange’s CME Globex or the Intercontinental Exchange’s Ice Trading.
The past few decades have also seen the introduction of smaller sized electronically traded contracts (referred to as “e-Minis”), which proved highly popular and witnessed an explosion in trading volumes.
Now that you know what futures contracts are, click on the link below to find out why futures trading has become such a popular method of price speculation.
|View the next futures article: Who Trades in the Futures Markets?|