Futures Market Overview

Futures exchanges

Futures markets began as a way for producers and buyers of various agricultural commodities to better manage the risks of price fluctuations by allowing them to lock in a current price. For example, a producer of wheat may think that the price will fall, so sells a contract at the current price. If the price falls, he has sold at the current price. If it rises, he forgoes the increase in price, but will get the current price.Now there are a number of futures exchanges around the world that provide standardised contracts for protecting against price fluctuations (hedging) or speculation in a range of markets including:

• Grains - wheat, corn, soybeans
• Softs - sugar, coffee, cocoa
• Agricultural commodities - rubber, jute, cotton, orange juice, pork bellies
• Base and precious metals - gold, silver, copper, zinc, aluminum
• Energy - oil, electricity
• Stock indices - NASDAQ, S&P
• Interest rates - treasury bonds, treasury bills, bank bills

 Each exchange provides a mechanism for buyers and sellers to transact, and ensures that contracts are honoured by the participants. Each buyer or seller puts up a good faith deposit called a margin. This is typically a few percent of the total value of the contract. This allows a small amount of margin to control a large value. This leverage means that a small fluctuation in the futures contract can result in a large profit or loss to the trader.The exchange requires that all participants have their positions “marked to market” every day. This means that fluctuations are added or subtracted from the trader’s account. If an account doesn’t have enough money to cover the movement, a margin call is issued. The trader must immediately provide more cash to cover the loss. This protects the integrity of the trade by ensuring that all participants can meet their obligations.

Futures market participants

There are three main categories of players in the futures market. They include “Hedgers,” “Speculators,” and “Floor Traders.” Each has a unique role in the futures market and futures trading could not work without the involvement of all three players.Hedgers are those individuals or companies which have a primary interest in a particular commodity. For agricultural products, hedgers might consist of the farmers who grow a particular agricultural product, and food product manufacturers who need the particular agricultural product to produce a food item. Hedgers try to establish a future price of a commodity so that they can more accurately plan future production.Speculators, on the other hand, have no direct involvement in the commodity being traded. Their only goal is to make money by buying and selling futures contracts. Most futures traders are speculators rather than hedgers. Speculators help the market to run efficiently by taking on risk from hedgers, and also the add liquidity to the market (to ensure that participants can trade at market price that reflects the value of the futures contract.Floor traders, locals, members or market makers can trade directly on their own account rather than through a broker. In futures markets that still have a trading floor, these traders directly buy and sell contracts. These traders provide liquidity to the market, and are often called market makers. They hold membership of the futures exchange.Brokers allow speculators who don’t have direct access to the market to trade through them. They will buy and sell futures contracts in accordance with your instructions and provide account keeping services in return for a brokerage fee. Most traders will need a broker, unless they plan to hold their own membership of the futures exchange (which is expensive and rare). Brokers also provide some research, and often recommendations.Although individuals often become speculators, large organisations such as hedge funds also trade. Their goals are the same as for individuals - to make a profit. Professional traders have some advantages - their trading costs are very low, they are experienced and well capitalised, and can move quickly. They get well paid to win, and they usually take money from the pockets of less experienced traders. Their low costs mean that they can make a profit on smaller movements.However individual traders can now access lower costs through the Internet and often have access to the same information. The main benefit that the individual trader has is that he or she doesn’t need to trade all the time, you can wait for the right moment, then decide to enter the market. Professional traders do need to trade quite often.As an individual trader, you will need to adopt the same disciplined approach used by a professional trader, whilst remembering that they have the advantage in trading speed and low costs.