By the s, grain elevators and railroads facilitated high volume grain storage and shipment, respectively. Consequently, country merchants and their Chicago counterparts required greater financing in order to store and ship this higher volume of grain.
For example, because a bushel of grade No. Merchants could secure these larger loans more easily and at relatively lower rates if they obtained firm price and quantity commitments from their buyers. So, merchants began to engage in forward not futures contracts. It specified that 3, bushels of corn were to be delivered to Chicago in June at a price of one cent below the March 13 th cash market price In the s and s these exchanges emerged as associations for dealing with local issues such as harbor infrastructure and commercial arbitration e.
By the s they established a system of staple grades, standards and inspections, all of which rendered inventory grain fungible Baer and Saxon , 10; Chandler , As collection points for grain, cotton, and provisions, they weighed, inspected and classified commodity shipments that passed from west to east.
They also facilitated organized trading in spot and forward markets Chandler , ; Odle , The largest and most prominent of these exchanges was the Board of Trade of the City of Chicago, a grain and provisions exchange established in by a State of Illinois corporate charter Boyle , 38; Lurie , 27 ; the exchange is known today as the Chicago Board of Trade CBT. For at least its first decade, the CBT functioned as a meeting place for merchants to resolve contract disputes and discuss commercial matters of mutual concern.
Participation was part-time at best. However, in the CBT became a state- of Illinois chartered private association. By the s traders sold and resold forward contracts prior to actual delivery Hieronymus , A trader could not offset, in the futures market sense of the term, a forward contact. Nonetheless, the existence of a secondary market — market for extant, as opposed to newly issued securities — in forward contracts suggests, if nothing else, speculators were active in these early time contracts.
On March 27, , the Chicago Board of Trade adopted its first rules and procedures for trade in forwards on the exchange Hieronymus , The rules addressed contract settlement, which was and still is the fundamental challenge associated with a forward contract — finding a trader who was willing to take a position in a forward contract was relatively easy to do; finding that trader at the time of contract settlement was not. The CBT began to transform actively traded and reasonably homogeneous forward contracts into futures contracts in May, At this time, the CBT: restricted trade in time contracts to exchange members; standardized contract specifications; required traders to deposit margins; and specified formally contract settlement, including payments and deliveries, and grievance procedures Hieronymus , The inception of organized futures trading is difficult to date.
This is due, in part, to semantic ambiguities — e. However, most grain trade historians agree that storage grain elevators , shipment railroad , and communication telegraph technologies, a system of staple grades and standards, and the impetus to speculation provided by the Crimean and U. Nonetheless, futures exchanges in the mids lacked modern clearinghouses, with which most exchanges began to experiment only in the mids.
The earliest formal clearing and offset procedures were established by the Minneapolis Grain Exchange in Peck , 6. Even so, rudiments of a clearing system — one that freed traders from dealing directly with one another — were in place by the s Hoffman , That is to say, brokers assumed the counter-position to every trade, much as clearinghouse members would do decades later. Brokers settled offsets between one another, though in the absence of a formal clearing procedure these settlements were difficult to accomplish.
Direct settlements were simple enough. Here, two brokers would settle in cash their offsetting positions between one another only. Nonetheless, direct settlements were relatively uncommon because offsetting purchases and sales between brokers rarely balanced with respect to quantity. For example, B1 might buy a 5, bushel corn future from B2, who then might buy a 6, bushel corn future from B1; in this example, 1, bushels of corn remain unsettled between B1 and B2.
Of course, the two brokers could offset the remaining 1, bushel contract if B2 sold a 1, bushel corn future to B1. But what if B2 had already sold a 1, bushel corn future to B3, who had sold a 1, bushel corn future to B1? Brokers referred to such a meeting as a ring settlement. Finally, if, in this example, B1 and B3 did not have positions with each other, B2 could settle her position if she transferred her commitment which she has with B1 to B3.
Brokers referred to this method as a transfer settlement. In either ring or transfer settlements, brokers had to find other brokers who held and wished to settle open counter-positions. Often brokers used runners to search literally the offices and corridors for the requisite counter-parties see Hoffman , Finally, the transformation in Chicago grain markets from forward to futures trading occurred almost simultaneously in New York cotton markets.
Forward contracts for cotton traded in New York and Liverpool, England by the s. And, like Chicago, organized trading in cotton futures began on the New York Cotton Exchange in about ; rules and procedures formalized the practice in Data on grain futures volume prior to the s are not available Hoffman , Indeed, Chart 1 demonstrates that trading was relatively voluminous in the nineteenth century.
An annual average of 23, million bushels of grain futures traded between and , or eight times the annual average amount of crops produced during that period. By comparison, an annual average of 25, million bushels of grain futures traded between and , or four times the annual average amount of crops produced during that period. In , futures volume outnumbered crop production by a factor of eleven. The comparable data for cotton futures are presented in Chart 2.
Again here, trading in the nineteenth century was significant. To wit, by futures volume had outnumbered production by a factor of five, and by this factor had reached eight. Nineteenth century observers of early U. To be sure, the performance of early futures markets remains relatively unexplored.
The extant research on the subject has generally examined this performance in the context of two perspectives on the theory of efficiency: the price of storage and futures price efficiency more generally. Holbrook Working pioneered research into the price of storage — the relationship, at a point in time, between prices of storable agricultural commodities applicable to different future dates Working , Or, what is the relationship between the current September futures price of wheat and the current May futures price of wheat?
Working reasoned that these prices could not differ because of events that were expected to occur between these dates. For example, if the May wheat futures price is less than the September price, this cannot be due to, say, the expectation of a small harvest between May and September On the contrary, traders should factor such an expectation into both May and September prices.
And, assuming that they do, then this difference can only reflect the cost of carrying — storing — these commodities over time. So, for example, the September price equals the May price plus the cost of storing wheat between May and September If the difference between these prices is greater or less than the cost of storage, and the market is efficient, arbitrage will bring the difference back to the cost of storage — e.
Working demonstrated empirically that the theory of the price of storage could explain quite satisfactorily these inter-temporal differences in wheat futures prices at the CBT as early as the late s Working , Many contemporary economists tend to focus on futures price efficiency more generally for example, Beck ; Kahl and Tomek ; Kofi ; McKenzie, et al.
Here, the research focuses on the relationship between, say, the cash price of wheat in September and the September futures price of wheat quoted two months earlier in July Figure 1illustrates the behavior of corn futures prices and their corresponding spot prices between and The data consist of the average month t futures price in the last full week of month t -2 and the average cash price in the first full week of month t.
The futures price and its corresponding spot price need not be equal; futures price efficiency does not mean that the futures market is clairvoyant. But, a difference between the two series should exist only because of an unpredictable forecast error and a risk premium — futures prices may be, say, consistently below the expected future spot price if long speculators require an inducement, or premium, to enter the futures market.
Recent work finds strong evidence that these early corn and corresponding wheat futures prices are, in the long run, efficient estimates of their underlying spot prices Santos , Nineteenth century America was both fascinated and appalled by futures trading. This is apparent from the litigation and many public debates surrounding its legitimacy Baer and Saxon , 55; Buck , , ; Hoffman , 29, ; Irwin , 80; Lurie , 53, Many agricultural producers, the lay community and, at times, legislatures and the courts, believed trading in futures was tantamount to gambling.
The difference between the latter and speculating, which required the purchase or sale of a futures contract but not the shipment or delivery of the commodity, was ostensibly lost on most Americans Baer and Saxon , 56; Ferris , 88; Hoffman , 5; Lurie , 53, Many Americans believed that futures traders frequently manipulated prices.
This manipulation continued throughout the century and culminated in the Three Big Corners — the Hutchinson , the Leiter , and the Patten Two nineteenth century challenges to futures trading are particularly noteworthy.
The first was the so-called Anti-Option movement. According to Lurie , the movement was fueled by agrarians and their sympathizers in Congress who wanted to end what they perceived as wanton speculative abuses in futures trading Although options were are not futures contracts, and were nonetheless already outlawed on most exchanges by the s, the legislation did not distinguish between the two instruments and effectively sought to outlaw both Lurie , However, in the Hatch and Washburn Anti-Option bills passed both houses of Congress, and failed only on technicalities during reconciliation between the two houses.
Had either bill become law, it would have effectively ended options and futures trading in the United States Lurie , A second notable challenge was the bucket shop controversy, which challenged the legitimacy of the CBT in particular. A bucket shop was essentially an association of gamblers who met outside the CBT and wagered on the direction of futures prices. The bucket shop controversy was protracted and colorful see Lurie , The CBT believed these laws entitled them to restrict bucket shops access to CBT price quotes, without which the bucket shops could not exist.
Bucket shops argued that they were competing exchanges, and hence immune to extant anti-bucket shop laws. As such, they sued the CBT for access to these price quotes. After roughly twenty years of litigation, the Supreme Court of the U. Bucket shops disappeared completely by Hieronymus , First, prior to , the opposition tried unsuccessfully to outlaw rather than regulate futures trading.
Second, strong agricultural commodity prices between and weakened the opposition, who blamed futures markets for low agricultural commodity prices Hieronymus , Grain prices fell significantly by the end of the First World War, and opposition to futures trading grew once again Hieronymus , In the U.
Congress enacted the Grain Futures Act, which required exchanges to be licensed, limited market manipulation and publicized trading information Leuthold , To discipline an exchange was essentially to suspend it, a punishment unfit too harsh for most exchange-related infractions. The Commodity Exchange Act of enabled the government to deal directly with traders rather than exchanges. Department of Agriculture, to monitor and investigate trading activities and prosecute price manipulation as a criminal offense.
Throughout the 21st century, like most other markets, futures exchanges have become mostly electronic. Futures contracts are made in an attempt by producers and suppliers of commodities to avoid market volatility. These producers and suppliers negotiate contracts with an investor who agrees to take on both the risk and reward of a volatile market. Futures markets or futures exchanges are where these financial products are bought and sold for delivery at some agreed-upon date in the future with a price fixed at the time of the deal.
Futures markets are for more than simply agricultural contracts, and now involve the buying, selling and hedging of financial products and future values of interest rates. Futures contracts can be made or "created" as long as open interest is increased, unlike other securities that are issued.
The size of futures markets which usually increase when the stock market outlook is uncertain is larger than that of commodity markets, and are a key part of the financial system. Large futures markets run their own clearinghouses , where they can both make revenue from the trading itself and from the processing of trades after the fact.
Some of the biggest futures markets that operate their own clearing houses include the Chicago Mercantile Exchange , the ICE, and Eurex. Clearnet, respectively settle trades. Exchanges are usually regulated by the nations regulatory body in the country in which they are based. Futures market exchanges earn revenue from actual futures trading and the processing of trades, as well as charging traders and firms membership or access fees to do business.
The investor agrees that if the price for coffee goes below a set rate, the investor agrees to pay the difference to the coffee farmer. If the price of coffee goes higher than a certain price, the investor gets to keep profits. For the roaster, if the price of green coffee goes above an agreed rate, the investor pays the difference and the roaster gets the coffee at a predictable rate. If the price of green coffee is lower than an agreed-upon rate, the roaster pays the same price and the investor gets the profit.
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That could be a problem because he has already published his catalog for a year ahead. In effect, the hedge provided insurance against an increase in the price of gold. Had the price of gold declined instead of risen, he would have incurred a loss on his futures position but this would have been offset by the lower cost of acquiring gold in the cash market. The number and variety of hedging possibilities is practically limitless. A cattle feeder can hedge against a decline in livestock prices and a meat packer or supermarket chain can hedge against an increase in livestock prices.
Borrowers can hedge against higher interest rates, and lenders against lower interest rates. Investors can hedge against an overall decline in stock prices, and those who anticipate having money to invest can hedge against an increase in the over-all level of stock prices.
And the list goes on. Whatever the hedging strategy, the common denominator is that hedgers willingly give up the opportunity to benefit from favorable price changes in order to achieve protection against unfavorable price changes.
Were you to speculate in futures contracts, the person taking the opposite side of your trade on any given occasion could be a hedger or it might well be another speculator--someone whose opinion about the probable direction of prices differs from your own. The arithmetic of speculation in futures contracts--including the opportunities it offers and the risks it involves--will be discussed in detail later on. For now, suffice it to say that speculators are individuals and firms who seek to profit from anticipated increases or decreases in futures prices.
In so doing, they help provide the risk capital needed to facilitate hedging. Someone who expects a futures price to increase would purchase futures contracts in the hope of later being able to sell them at a higher price.
This is known as "going long. The practice of selling futures contracts in anticipation of lower prices is known as "going short. Floor Traders. Persons known as floor traders or locals, who buy and sell for their own accounts on the trading floors of the exchanges, are the least known and understood of all futures market participants. Yet their role is an important one. Like specialists and market makers at securities exchanges, they help to provide market liquidity.
If there isn't a hedger or another speculator who is immediately willing to take the other side of your order at or near the going price, the chances are there will be an independent floor trader who will do so, in the hope of minutes or even seconds later being able to make an offsetting trade at a small profit.
In the grain markets, for example, there is frequently only one-fourth of a cent a bushel difference between the prices at which a floor trader buys and sells. Floor traders, of course, have no guarantee they will realize a profit. They may end up losing money on any given trade.
Their presence, however, makes for more liquid and competitive markets. It should be pointed out, however, that unlike market makers or specialists, floor traders are not obligated to maintain a liquid market or to take the opposite side of customer orders. Reasons for Buying futures contracts Reasons for Selling futures contracts Hedgers To lock in a price and thereby obtain protection against rising prices To lock in a price and thereby obtain protection against declining prices Speculators and floor Traders To profit from rising prices To profit from declining prices.
What is a Futures Contract? There are two types of futures contracts, those that provide for physical delivery of a particular commodity or item and those which call for a cash settlement. The month during which delivery or settlement is to occur is specified. Thus, a July futures contract is one providing for delivery or settlement in July.
It should be noted that even in the case of delivery-type futures contracts,very few actually result in delivery. Treasury bills for that matter. Rather, the vast majority of speculators in futures markets choose to realize their gains or losses by buying or selling offsetting futures contracts prior to the delivery date. Selling a contract that was previously purchased liquidates a futures position in exactly the same way, for example, that selling shares of IBM stock liquidates an earlier purchase of shares of IBM stock.
Similarly, a futures contract that was initially sold can be liquidated by an offsetting purchase. In either case, gain or loss is the difference between the buying price and the selling price. Even hedgers generally don't make or take delivery. Most, like the jewelry manufacturer illustrated earlier, find it more convenient to liquidate their futures positions and if they realize a gain use the money to offset whatever adverse price change has occurred in the cash market.
Why Delivery? Since delivery on futures contracts is the exception rather than the rule, why do most contracts even have a delivery provision? There are two reasons. One is that it offers buyers and sellers the opportunity to take or make delivery of the physical commodity if they so choose. More importantly, however, the fact that buyers and sellers can take or make delivery helps to assure that futures prices will accurately reflect the cash market value of the commodity at the time the contract expires--i.
It is convergence that makes hedging an effective way to obtain protection against an adverse change in the cash market price. This is known as arbitrage and is a form of trading generally best left to professionals in the cash and futures markets. Cash settlement futures contracts are precisely that, contracts which are settled in cash rather than by delivery at the time the contract expires.
Stock index futures contracts, for example, are settled in cash on the basis of the index number at the close of the final day of trading. There is no provision for delivery of the shares of stock that make up the various indexes. That would be impractical. With a cash settlement contract, convergence is automatic. The Process of Price Discovery. Futures prices increase and decrease largely because of the myriad factors that influence buyers' and sellers' judgments about what a particular commodity will be worth at a given time in the future anywhere from less than a month to more than two years.
As new supply and demand developments occur and as new and more current information becomes available, these judgments are reassessed and the price of a particular futures contract may be bid upward or downward. The process of reassessment--of price discovery--is continuous. Thus, in January, the price of a July futures contract would reflect the consensus of buyers' and sellers' opinions at that time as to what the value of a commodity or item will be when the contract expires in July.
On any given day, with the arrival of new or more accurate information, the price of the July futures contract might increase or decrease in response to changing expectations. Competitive price discovery is a major economic function--and, indeed, a major economic benefit--of futures trading. The trading floor of a futures exchange is where available information about the future value of a commodity or item is translated into the language of price.
In summary, futures prices are an ever changing barometer of supply and demand and, in a dynamic market, the only certainty is that prices will change. After the Closing Bell. Once a closing bell signals the end of a day's trading, the exchange's clearing organization matches each purchase made that day with its corresponding sale and tallies each member firm's gains or losses based on that day's price changes--a massive undertaking considering that nearly two-thirds of a million futures contracts are bought and sold on an average day.
Each firm, in turn, calculates the gains and losses for each of its customers having futures contracts. Gains and losses on futures contracts are not only calculated on a daily basis, they are credited and deducted on a daily basis. The process just described is known as a daily cash settlement and is an important feature of futures trading. As will be seen when we discuss margin requirements, it is also the reason a customer who incurs a loss on a futures position may be called on to deposit additional funds to his account.
The Arithmetic of Futures Trading. To say that gains and losses in futures trading are the result of price changes is an accurate explanation but by no means a complete explanation. Perhaps more so than in any other form of speculation or investment, gains and losses in futures trading are highly leveraged.
An understanding of leverage--and of how it can work to your advantage or disadvantage--is crucial to an understanding of futures trading. As mentioned in the introduction, the leverage of futures trading stems from the fact that only a relatively small amount of money known as initial margin is required to buy or sell a futures contract.
The smaller the margin in relation to the value of the futures contract, the greater the leverage. If you speculate in futures contracts and the price moves in the direction you anticipated, high leverage can produce large profits in relation to your initial margin. Conversely, if prices move in the opposite direction, high leverage can produce large losses in relation to your initial margin.
Leverage is a two-edged sword. Said another way, while buying or selling a futures contract provides exactly the same dollars and cents profit potential as owning or selling short the actual commodities or items covered by the contract, low margin requirements sharply increase the percentage profit or loss potential.
Futures trading thus requires not only the necessary financial resources but also the necessary financial and emotional temperament. An absolute requisite for anyone considering trading in futures contracts--whether it's sugar or stock indexes, pork bellies or petroleum--is to clearly understand the concept of leverage as well as the amount of gain or loss that will result from any given change in the futures price of the particular futures contract you would be trading.
If you cannot afford the risk, or even if you are uncomfortable with the risk, the only sound advice is don't trade. Futures trading is not for everyone. As is apparent from the preceding discussion, the arithmetic of leverage is the arithmetic of margins.
An understanding of margins--and of the several different kinds of margin--is essential to an understanding of futures trading. If your previous investment experience has mainly involved common stocks, you know that the term margin--as used in connection with securities--has to do with the cash down payment and money borrowed from a broker to purchase stocks.
But used in connection with futures trading, margin has an altogether different meaning and serves an altogether different purpose. Rather than providing a down payment, the margin required to buy or sell a futures contract is solely a deposit of good faith money that can be drawn on by your brokerage firm to cover losses that you may incur in the course of futures trading. It is much like money held in an escrow account.
Minimum margin requirements for a particular futures contract at a particular time are set by the exchange on which the contract is traded. They are typically about five percent of the current value of the futures contract. Exchanges continuously monitor market conditions and risks and, as necessary, raise or reduce their margin requirements.
Individual brokerage firms may require higher margin amounts from their customers than the exchange-set minimums. Initial margin sometimes called original margin is the sum of money that the customer must deposit with the brokerage firm for each futures contract to be bought or sold. On any day that profits accrue on your open positions, the profits will be added to the balance in your margin account. On any day losses accrue, the losses will be deducted from the balance in your margin account.
If and when the funds remaining available in your margin account are reduced by losses to below a certain level--known as the maintenance margin requirement--your broker will require that you deposit additional funds to bring the account back to the level of the initial margin. Or, you may also be asked for additional margin if the exchange or your brokerage firm raises its margin requirements.
Requests for additional margin are known as margin calls. Before trading in futures contracts, be sure you understand the brokerage firm's Margin Agreement and know how and when the firm expects margin calls to be met. Some firms may require only that you mail a personal check. Others may insist you wire transfer funds from your bank or provide same-day or next-day delivery of a certified or cashier's check.
If margin calls are not met in the prescribed time and form, the firm can protect itself by liquidating your open positions at the available market price possibly resulting in an unsecured loss for which you would be liable. Basic Trading Strategies. Even if you should decide to participate in futures trading in a way that doesn't involve having to make day-to-day trading decisions such as a managed account or commodity pool , it is nonetheless useful to understand the dollars and cents of how futures trading gains and losses are realized.
And, of course, if you intend to trade your own account, such an understanding is essential. Dozens of different strategies and variations of strategies are employed by futures traders in pursuit of speculative profits.
Here is a brief description and illustration of several basic strategies. Someone expecting the price of a particular commodity or item to increase over from a given period of time can seek to profit by buying futures contracts.
If correct in forecasting the direction and timing of the price change, the futures contract can later be sold for the higher price, thereby yielding a profit. Because of leverage, the gain or loss may be greater than the initial margin deposit. While most speculative futures transactions involve a simple purchase of futures contracts to profit from an expected price increase--or an equally simple sale to profit from an expected price decrease--numerous other possible strategies exist.
Spreads are one example. A spread, at least in its simplest form, involves buying one futures contract and selling another futures contract. The purpose is to profit from an expected change in the relationship between the purchase price of one and the selling price of the other. Your analysis of market conditions indicates that, over the next few months, the price difference between the two contracts will widen to become greater than 5 cents.
To profit if you are right, you could sell the March futures contract the lower priced contract and buy the May futures contract the higher priced contract. By liquidating both contracts at this time, you can realize a net gain of 10 cents a bushel.
Net gain 10 cents Bu. Gain on 5, Bu. Virtually unlimited numbers and types of spread possibilities exist, as do many other, even more complex futures trading strategies. Participating in Futures Trading. Now that you have an overview of what futures markets are, why they exist and how they work, the next step is to consider various ways in which you may be able to participate in futures trading.
There are a number of alternatives and the only best alternative--if you decide to participate at all--is whichever one is best for you. Also discussed is the opening of a futures trading account, the regulatory safeguards provided participants in futures markets, and methods for resolving disputes, should they arise. Deciding How to Participate. At the risk of oversimplification, choosing a method of participation is largely a matter of deciding how directly and extensively you, personally, want to be involved in making trading decisions and managing your account.
Many futures traders prefer to do their own research and analysis and make their own decisions about what and when to buy and sell. That is, they manage their own futures trades in much the same way they would manage their own stock portfolios. Others choose to rely on or at least consider the recommendations of a brokerage firm or account executive. Some purchase independent trading advice.
Others would rather have someone else be responsible for trading their account and therefore give trading authority to their broker. Still others purchase an interest in a commodity trading pool. There's no formula for deciding.
Your decision should, however, take into account such things as your knowledge of and any previous experience in futures trading, how much time and attention you are able to devote to trading, the amount of capital you can afford to commit to futures, and, by no means least, your individual temperament and tolerance for risk.
The latter is important. Some individuals thrive on being directly involved in the fast pace of futures trading, others are unable, reluctant, or lack the time to make the immediate decisions that are frequently required. Some recognize and accept the fact that futures trading all but inevitably involves having some losing trades. Others lack the necessary disposition or discipline to acknowledge that they were wrong on this particular occasion and liquidate the position. Many experienced traders thus suggest that, of all the things you need to know before trading in futures contracts, one of the most important is to know yourself.
This can help you make the right decision about whether to participate at all and, if so, in what way. In no event, it bears repeating, should you participate in futures trading unless the capital you would commit its risk capital. That is, capital which, in pursuit of larger profits, you can afford to lose. It should be capital over and above that needed for necessities, emergencies, savings and achieving your long-term investment objectives.
You should also understand that, because of the leverage involved in futures, the profit and loss fluctuations may be wider than in most types of investment activity and you may be required to cover deficiencies due to losses over and above what you had expected to commit to futures. Trade Your Own Account. This involves opening your individual trading account and--with or without the recommendations of the brokerage firm--making your own trading decisions.
You will also be responsible for assuring that adequate funds are on deposit with the brokerage firm for margin purposes, or that such funds are promptly provided as needed.
Practically all of the major brokerage firms you are familiar with, and many you may not be familiar with, have departments or even separate divisions to serve clients who want to allocate some portion of their investment capital to futures trading. Different firms offer different services. Some, for example, have extensive research departments and can provide current information and analysis concerning market developments as well as specific trading suggestions.
Others tailor their services to clients who prefer to make market judgments and arrive at trading decisions on their own. Still others offer various combinations of these and other services.
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