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 Began
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?
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.
Hedging in the Futures Market
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, which is currently on the rise in Sri Lanka
Speculating in the Futures Market
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 - but by using online day trading commodities strategies.
