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Futures Technology 1630A 30th St # 365 Boulder, Colorado 80301 1-800-878-6070 303-442-6543 |
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| The Development of Futures TradingSince its origins in the 1800’s futures trading has experienced substantial changes relating to the scope of the markets, the nature of risks, the motivation of the participants, the patterns of industry, and the refinement of futures trading and clearing practices. The most notable difference is that in the early days of the futures exchanges the primary use of the market was to make or take delivery of the actual commodity, to find a buyer or seller. In contrast, today fewer than 3 percent of all futures contracts culminate in the delivery of the actual commodity against the contract. Both commercial and speculative users of the market generally find it preferable of offset, or liquidate, the obligation through as opposite futures transaction rather than by making or taking delivery. The early commodity exchanges of the 1800’s were essentially cash markets. Today, commodity exchanges are primarily financial markets in which the ability to buy or sell the actual commodity is secondary to protection against the financial risk of price volatility. CASH TRANSACTIONS A would-be seller owning merchandise, such as the farmer who owns 5,000 bushels of wheat, wants to convert it to cash. He seeks as a buyer someone for whom the wheat has potential value. The wheat has value for the grain-elevator operator because he is in contact with prospective buyers, such as the flour miller, and has the facilities to store, condition, and load out the grain. The wheat has value for the flour miller, in turn, who is able to increase its value and utility by grinding it into flour for the baker. The farmer’s sale to the grain elevator operator, the operator’s sale to the wheat miller, and the miller’s sale of flour to the baker are cash transactions. In each of these sales, certain common elements must be agreed upon. Quality, usually specified by the buyer, will sometimes be negotiated with price discounts allowed for increased quantity. The where, when, and how of delivery terms must be settled as well. And, finally, price will be determined in reference to the other terms of the contract quality, quantity, and the time and place of delivery. Cash contracts are usually agreements for the immediate delivery of commodities or for negotiated future delivery. A cash contract on which merchandise is not to be delivered immediately but on as agreed-upon future date is known as a cash forward contract. A cash forward contract might be more appropriate than the usual cash transaction for a flour miller if his storage capacity is already fully utilized. By using a cash forward contract, the miller would be guaranteed a source of supply but could defer delivery until the time at which he could process the wheat. A cash forward contract enables buyers and sellers of commodities to properly plan for and utilize both storage and production facilities and to make commitments for deferred deliveries of the commodity or of further-processed products. The flour miller might enter into a cash forward contract to deliver flour to the baker when the baker could put it to immediate use, avoiding the need for storage. A cash forward seller of grain or flour might not even have the grain or flour at the time he enters into the contract. Yet he can contract to sell it in the belief that he will be able to acquire the commodity at a favorable price in time to satisfy the delivery requirements of his customer. In negotiating a cash forward contract, the buyer may require from the seller a guarantee of a specific grade or quality of the commodity. In the event the seller is unable to deliver that specific grade, it is common for the seller and buyer to agree on price adjustments. When delivery occurs, the commodity is carefully inspected and its grade determined. Payment of a premium is usual when the grade is higher than the standard, or a discount in price is accepted when the grade is inferior. FUTURES CONTRACTS Because futures contracts evolved from cash forward contracts, they have similar terms. A futures contract is a legally binding commitment to deliver or take delivery of a given quantity and quality of a commodity at a price agreed upon in the trading pit or ring of a commodity exchange at the time the contract is executed. The seller has the option to deliver the commodity sometime during a specified future delivery month. Delivery against a futures contract with a commodity of a superior or inferior quality may be made at a premium over or a discount under the agreed-upon price. Futures contracts are cleared through the clearinghouse division or separate clearing corporation of a commodity exchange. The clearing corporation thereby assumes the responsibility to buyer and seller, respectively, as a third-party guarantor of the transaction. Standardization of futures contracts as to grade, size, and delivery evolved gradually. Standardization allowed for the growth of the market because one futures contract for a specific commodity became identical and interchangeable with all other futures contracts of the same delivery month for the same commodity. This interchangeability meant that the original seller could offset his obligation to deliver the commodity against the contract, once his price risk had ended, by offsetting or liquidating the contract with an equal and opposite purchase of a futures contract. The buyer, of course, had the same ability to offset his obligation to take delivery of the actual commodity, once his price risk ended, through an equal and opposite sale of a futures contract. Standardization of terms and the ability to offset contracts led to rapidly increasing use of the futures markets by commercial firms and speculators. Commercial firms began to realize that futures markets could provide financial protection against price volatility without the necessity of making or taking delivery against the futures contract. HEDGING Commercial firms, producers, merchandisers, and processors of commodities recognized a generally parallel pattern in price movements between cash commodities and futures contracts for those commodities. News that bad weather would likely result in crop losses and tighter supplies was reflected immediately in higher cash prices as buyers sought to buy and store the commodity in anticipation of later shortages. Futures prices were also bid higher as buyers anticipated the impact of the shortages, not only at harvest but through the balance of the marketing year. Economic news, on the other hand, that signaled higher-than-expected supplies was immediately registered in weakening cash prices as buyers lowered bids in anticipation of easily available supplies. At the same time, in the futures market, buyers scaled down bids with the prospects of increased supplies. Commercial firms noted the strong tendency for cash and futures prices to move in the same direction by roughly equal amounts, reacting to the same economic factors. These firms realized that, although a single set of economic factors might result in a loss on a cash transaction, it could also be turned into a profit in the futures market if a position were taken equal but opposite to the risk position in the cash market. A businessman, for example, who lacked a commodity but who was committed to processing and sales agreements, ran the risk that prices would rise before the could buy the commodity. He was short the cash commodity, so he would take an equal but opposite long position by buying futures contracts. A wheat-flour miller, for instance, might be committed to deliver 50 bags of flour to a baker at a fixed price at a time in the future. He might not yet have bought the wheat, lacking the space to store it until it would be processed. A sudden rise in wheat prices could spell a serious loss; his raw material costs would climb while his sales income would remain fixed. The wheat-flour miller could have some protection through the use of futures. To protect himself, or hedge his risk, the miller would buy wheat futures contracts in an amount roughly equal to the amount of grain needed to make the flour he had agreed to deliver to the baker. He would buy futures contracts in the futures delivery month closest to the time he had to buy the wheat to process the flour. When he needed it, he would buy the wheat in the cash market, offsetting his purchase of wheat futures contracts with an equal sale, and manufacture the flour and deliver it to his customer. Let us say that wheat prices had risen. If the miller had not hedged in the futures market, he might be faced with smaller profits, a break-even situation, or a substantial loss. However, although the cash cost of the wheat had risen, wiping out or cutting his profits, futures prices would have also responded to the same economic factors. The wheat futures prices would also be higher than at the time he purchased the contracts. In selling futures at the later higher prices, the flour miller could recover his loss from increased cash cost. The risk for the producer is that the value of his commodities will decline before he can market them. The risk for the processor or user of the commodities is the reverse, that the supply situation will tighten so that rising prices will add to his costs and impair his profits. The producer or owner of the commodities will use a selling, short, hedge as a protection against declining values. The user of the commodities will use a buying, long, hedge in the futures market to protect against rising prices. SPECULATION Along with commercial producers and users of commodities, speculators noted the inherent price volatility in commodities and the tendency to parallel the movements in the cash and futures prices. They may have had no particular commercial interest in commodities but were attracted by the possibility of gain from the changing prices. The standardization of futures contracts added appeal in that they could be bought and later sold, or sold and later bought, at a profit if the speculator were correct in his forecast of price movement. Offsetting transaction eliminated the initial obligation to take or make delivery of the actual commodity. Because of the absence of records, it is not known precisely when speculators became an important segment of the futures market, but it is generally thought that they were active at the time of the Civil War. Although the late 1800’s were filled with incidents of public outrage against alleged speculative abuses in commodities and securities markets, the self-regulatory efforts of the exchanges went far to correct problems. It soon became apparent that the presence of speculators in the market was economically beneficial in providing the ready liquidity to absorb the growing commercial hedging activity. PRICE INFORMATION Price information is a major economic contribution of futures markets. Futures prices have become the most widely used pricing reference in domestic and international trade in basic commodities. Participants in futures markets are constantly adjusting their bids and offers to buy and sell contracts in relation to a continuous flow of worldwide market information. For example, news of Brazilian soybean crop conditions will be sought, analyzed, and then absorbed almost instantaneously in the price of oilseed futures. The impact of nationalization of foreign-owned copper mines will immediately be registered in the price of copper, silver, and other related futures in New York, London, and Chicago. CLEARING OPERATIONS Standardization of contract terms made it possible for commercial and speculative users to offset obligations through opposite futures trades, and also permitted the development of clearing operations in which the clearinghouse of an exchange acted as a third-party guarantor to all transactions. On a day-to-day basis, a clearinghouse acts as seller to all buyers and as buyer to all sellers. This eliminates the need for keeping track of the complex and long list of successive buyers and sellers of specific contracts. The clearinghouse, in its daily records, maintains an accounting of who has bought and sold futures contracts, clearing accounts as participants liquidate their obligations through offsetting transactions. If a seller chooses to deliver, he will issue a notice to the clearinghouse, which will assign it to a long or buyer listed on its records, and the two parties will arrange for payment and transfer of title to the commodity. PERFORMANCE MARGINS The concept of performance margins is very old, and in modern commerce the idea of depositing money as a performance bond on a contract is not unique to futures contracts. Margin in commodity futures markets have the same function as that of a performance bond. They are not, in fact, equity payment against the market value of the commodity represented by the contract but a guarantee required of both buyers and sellers that they will respectively make and take delivery of the commodity represented by the contract unless obligation to do so is offset through and opposite transaction. By exchange regulations, commodity brokerage firms require customers to deposit margins to assure their performance against the obligations undertaken by the firms in their behalf. Clearinghouse regulations require that margins be deposited by clearing member firms to assure, in turn, that these firms will stand by their obligations. The financial integrity of the clearing operation is tied to stringent financial requirements for clearing member firms, and these are bolstered by the deposits required of individual customers, both buyers and sellers, speculators and hedgers. Customer margins and clearing member firm margins are determined on the basis of probable risk of loss. Customer margins must be maintained at a specified minimum. When price movement reduces the margin to a specified extent, additional deposits are required to bring the margin deposit back to the initial level. Similarly, initial clearing member firm margins must be maintained at a specified level. The accounts of clearing member firms are settled daily on a cash basis. If price movements have resulted in a loss, the clearing member is required to make an additional deposit prior to the opening of the market on the next business day. In periods of great volatility, there may be calls made to clearing members during a market session requiring immediate posting of additional margin money. These are commonly called variation margins. Because they are geared to probable risk, margins help assure the financial soundness of commodity exchanges and provide valuable price protection for commercial hedgers with a minimum tie-up of capital. Margins for speculators are normally set at from 5 to 15 percent of the value of the commodity represented by the contract. As a result, they offer financial leverage unique among investment vehicles. PRICE THEORY AND FUTURES MARKETS Changes in quantities of a commodity demanded or supplied may depend on a variety of factors. These include changes in the price of the commodity, changes in the supply or demand for the commodity at all prices, the price of related commodities, and income in general. In price theory, the concept of demand refers to the total quantity of a given commodity that will be purchased at a given price. Conversely, the concept of supply refers to the total quantity of a particular commodity offered for sale at a given price. Supply and demand schedules show the variable quantities of commodities either demanded or supplied at various prices. Points plotted on graphs to show the varying quantities purchased at varying price levels form supply / demand curves. Movements along a supply or demand curve reflect changes in the quantity of a commodity demanded or supplied that results from a change in the price of the commodity. As the price of a commodity increases, for example, the quantity purchased decreases. Conversely, if the price of a commodity decreases, the quantity purchased increases. The underlying schedule of demand, however, does not change; only the prices prevailing in the market change. The demand for the commodity adjusts to reflect changes in its market price. As prices change, equilibrium price is determined that balances supply and demand and permits a transaction. The equilibrium price is that price above which prospective buyers will not buy and below which prospective sellers will not sell. The equilibrium price changes continuously to provide a balance between supply and demand. The adjustment of demand resulting from a percentage change in the price of a commodity is called the elasticity of demand. Elasticity of demand is, simply, the relative change in the quantity of a commodity purchased resulting form a percentage change in its price. If a percentage change in price leads to a large percentage change in the amount of the commodity demanded, the demand for that commodity is referred to as price elastic. If a percentage change in the price of a commodity results in a relatively small percentage change in the quantity of the commodity bought, the demand for the commodity is described as price inelastic. The reaction of demand for a commodity to a change in its price is summarized by the Law of Demand. The Law of Demand specifies that the demand for a commodity increases as the price of the commodity decreases. Conversely, the Law of Demand specifies that the demand for a commodity decreases as its price increases. The percentage change in the amount of commodity supplied relative to a percentage change in price is called elasticity of supply. If a percentage change in the price of a commodity results in a greater relative increase in the supply of the commodity offered, the supply is described as being elastic. Conversely, if the amount of a commodity offered for sale does not increase at rate as great as the increase in its price, the supply of the commodity is said to be inelastic. The reaction of the quantity of a commodity supplied to a change in its price is summarized by the Law of Supply. That law stipulates that, as the market price of a commodity increases, more of the product will be offered for sale. Conversely, the Law of Supply states that a decline in the market price of a commodity will curtail the quantity offered for sale. Basic supply and demand situations are affected by government policy and actions. In the current world economy, there is little of the free or pure competition that once existed. Governments for centuries have imposed taxes, tariffs, and levies to curtail or discourage trade with other nations in basic commodities in order to support domestic prices against external competition. While it is unlikely that the economy will ever return to one of totally free competition, commodity futures markets seem to most closely resemble a free competitive model.
The Rules and Regulations of the different Commodity Exchange should be consulted as the authoritative source for information, rules and contract specifications. PLEASE NOTE THAT THERE IS AN INHERENT RISK OF LOSS ASSOCIATED WITH TRADING FUTURES AND OPTIONS CONTRACTS. EMPLOYEES OF FUTURES TECHNOLOGY, LLC PROVIDE INFORMATION BASED ON SOURCES WE CONSIDER RELIABLE, BUT THERE IS NO GUARANTEE THAT THE INFORMATION WE PROVIDE WILL RESULT IN PROFITABLE TRADES. PLEASE CAREFULLY CONSIDER YOUR FINANCIAL CONDITION BEFORE INVESTING IN FUTURES AND OPTIONS CONTRACTS. FUTURES TRADING IS NOT SUITABLE FOR ALL INVESTORS. PAST PERFORMANCE IS NOT NECESSARY INDICATIVE OF FUTURE RESULTS. This Site is Designed, Built and
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