A Short History of Futures Trading
Before Futures Trading came about, any producer of a commodity (e.g. a farmer growing wheat or corn) found himself at the mercy of a dealer when it came to selling his product. The system needed to be legalised in order that a specified amount and quality of product could be traded between producers and dealers at a specified date.
Contracts were drawn up between the two parties specifying a certain amount and quality of a commodity that would be delivered in a particular month...
...Futures trading had begun!
In 1878, a central dealing facility was opened in Chicago, USA where farmers and dealers could deal in "spot" grain, i.e., immediately deliver their wheat crop for a cash settlement. Futures trading evolved as farmers and dealers committed to buying and selling future exchanges of the commodity. For example, a dealer would agree to buy 5,000 bushels of a specified quality of wheat from the farmer in June the following year, for a specified price. The farmer knew how much he would be paid in advance, and the dealer knew his costs.
Until twenty years ago, futures markets consisted of only a few farm products, but now they have been joined by a huge number of tradable "commodities". As well as metals like gold, silver and platinum; livestock like pork bellies and cattle; energies like crude oil and natural gas; foodstuffs like coffee and orange juice; and industrials like lumber and cotton, modern futures markets include a wide range of interest-rate instruments, currencies, stocks and other indices such
as the Dow Jones, Nasdaq and S&P 500.
Who Trades Futures?
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It didn"t take long for businessmen to realise the lucrative investment opportunities
available in these markets. They didn"t have to buy or sell the ACTUAL commodity (wheat or corn, etc.), just the paper-contract that held the commodity. As long as they exited the contract before the delivery date, the investment would be purely a paper one. This was the start of futures trading speculation and investment, and today, around 97% of futures trading is done by speculators.
There are two main types of Futures trader: "hedgers" and "speculators".
A hedger is a producer of the commodity (e.g. a farmer, an oil company, a mining company) who trades a futures contract to protect himself from future price changes in his product.
For example, if a farmer thinks the price of wheat is going to fall by harvest time, he can sell a futures contract in wheat. (You can enter a trade by selling a futures contract first, and then exit the trade later by buying it.) That way, if the cash price of wheat does fall by harvest time, costing the farmer money, he will make back the cash-loss by profiting on the short-sale of the futures contract. He "sold" at a high price and exited the contract by "buying" at a lower price a few months later, therefore making a profit on the futures trade.
Other hedgers of futures contracts include banks, insurance companies and pension fund companies who use futures to hedge against any fluctuations in the cash price of their products at future dates.
Speculators include independent floor traders and private investors. Usually, they don"t have any connection with the cash commodity and simply try to (a) make a profit buying a futures contract they expect to rise in price or (b) sell a futures contract they expect to fall in price.
In other words, they invest in futures in the same way they might invest in stocks and shares - by buying at a low price and selling at a higher price.
The Advantages of Trading Futures
Trading futures contracts have several advantages over other investments:
1. Futures are highly leveraged investments. To "own" a futures contract an investor only has to put up a small fraction of the value of the contract (usually around 10%) as "margin". In other words, the investor can trade a much larger amount of the commodity than if he bought it outright, so if he has predicted the market movement correctly, his profits will be multiplied (ten-fold on a 10% deposit). This is an excellent return compared to buying a physical commodity like gold bars, coins or mining stocks.
The margin required to hold a futures contract is not a down payment but a form of security bond. If the market goes against the trader"s position, he may lose some, all, or possibly more than the margin he has put up. But if the market goes with the trader"s position, he makes a profit and he gets his margin back.
For example, say you believe gold in undervalued and you think prices will rise. You have £3000 to invest - enough to purchase:
- 10 ounces of gold (at £300/ounce)
- or 100 shares in a mining company (priced at £30 each)
or enough margin to cover 2 futures contracts. (Each Gold futures contract holds 100 ounces of gold, which is effectively what you "own" and are speculating with. One-hundred ounces multiplied by three-hundred dollars equals a value of £30,000 per contract. You have enough to cover two contracts and therefore speculate with £60,000 of gold!)
Two months later, gold has rocketed 20%. Your 10 ounces of gold and your company shares would now be worth £3600 - a £600 profit; 20% of £3000. But your futures contracts are now worth a staggering £72,000 - 20% up on £60,000.
Instead of a measly £600 profit, you"ve made a massive £12,000 profit!
2. Speculating with futures contracts is basically a paper investment. You don"t have to literally store 3 tons of gold in your garden shed, 15,000 litres of orange juice in your driveway, or have 500 live hogs running around your back garden!
The actual commodity being traded in the contract is only exchanged on the rare occasions when delivery of the contract takes place (i.e. between producers and dealers - the "hedgers" mentioned earlier on). In the case of a speculator (such as yourself), a futures trade is purely a paper transaction and the term "contract" is only used mainly because of the expiration date being similar to a "contract".
3. An investor can make money more quickly on a futures trade. Firstly, because he is trading with around ten-times as much of the commodity secured with his margin, and secondly, because futures markets tend to move more quickly than cash markets. (Similarly, an investor can lose money more quickly if his judgement is incorrect, although losses can be minimised with Stop-Loss Orders. My trading method specialises in placing stop-loss orders to maximum effect.)
4. Futures trading markets are usually fairer than other markets (like stocks and shares) because it is harder to get "inside information". The open out-cry trading pits -- lots of men in yellow jackets waving their hands in the air shouting "Buy! Buy!" or "Sell! Sell!" -- offers a very public, efficient market place. Also, any official market reports are released at the end of a trading session so everyone has a chance to take them into account before trading begins again the following day.
5. Most futures markets are very liquid, i.e. there are huge amounts of contracts traded every day. This ensures that market orders can be placed very quickly as there are always buyers and sellers of a commodity. For this reason, it is unusual for prices to suddenly jump to a completely different level, especially on the nearer contracts (those which will expire in the next few weeks or months).
6. Commission charges are small compared to other investments and are paid after the position has ended.
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