FuturesTrader Tools
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resources that commodity traders need. Also contact one of
our experienced futures brokers at 800-656-0443.
History of Futures.
The history of futures trading is, in a sense,
two histories, both focused on how people have
tried to improve the effectiveness of the commercial
marketplace. The early story is a tale of how
people in an agrarian society used forward contracts
(agreements to buy now, but pay and deliver
later) as a means of getting farm commodities
efficiently from producers to consumers, at
established prices and delivery terms, and how
those forward contracts evolved into futures
contracts. The present day story explains how
the futures industry reinvented itself in the
latter part of the twentieth century, essentially
by redefining the meaning of “commodity,”
so that it could accommodate the needs of complex
financial markets in a society whose economy
was no longer based primarily on agriculture.
The Early Story on commodities
Commodity markets have existed for centuries
around the world because producers and buyers
of foodstuffs and other items have always needed
a common place to trade. Cash transactions were
most common, but sometimes “forward”
agreements were also made – deals to deliver
and pay for something in the future at a price
agreed upon in the present. There are records,
for example, of “forward” agreements
related to the rice markets in seventeenth century
Japan; most scholars agree that forward arrangements
actually date back much farther in time.
The immediate predecessors of futures contracts
were “to arrive” contracts. These
were simple agreements to purchase designated
goods when they arrived by ship, and they were
used for centuries when shipping was the primary
mode of international trade.
The first organized grain futures trading in
the U.S. began in places such as New York City
and Buffalo, but the development of “modern”
futures, which are a unique type of forward
agreement, began in Chicago in the 1840s. With
the construction of the railroads, Chicago began
to emerge as a center for transportation between
midwestern producers and east coast population
centers. The city was a natural hub for trade,
but the trading that took place there was inefficient
and unorganized until a group of Chicago-based
business men formed the Board of Trade of the
City of Chicago in 1848. The Board was a member-owned
organization that offered a centralized location
for cash trading of a variety of goods as well
as trading of forward contracts. Members served
as brokers who facilitated trading in return
for commissions.
As trading of forward contracts increased,
the Board decided that standardizing those contracts
would streamline the trading and delivery processes.
Instead of individualized contracts, which took
a great deal of time to negotiate and fulfill,
people interested in the forward trading of
corn at the Board, for example, were asked to
trade contracts that were identical in terms
of quantity, quality, delivery month and terms,
all as established by the exchange. The only
thing left for traders to negotiate was price
and the number of contracts.
These standardized forwards were essentially
the first modern futures contracts. They were
unlike other forwards in that they could only
be traded at the exchange that created them,
and only at certain designated times. They were
also different from other forwards in that the
bids, offers and negotiated prices of the trades
were made public by the exchange. This practice
established futures exchanges as venues for
“price discovery” in U.S. markets.
In contrast to customized contracts, standardized
futures contracts were easy to trade, since
all trades were simply re-negotiations of price,
and they usually changed hands many times before
expiration. People who wanted to make a profit
based on a fortuitous price change, or alternatively,
who wished to cut mounting losses as quickly
as possible, could “offset” a futures
contract before expiration by engaging in an
opposite trade: buying a contract which they
had previously sold (or “gone short”),
or selling a contract which they had previously
bought (or “gone long”).
The usefulness of futures trading became apparent,
and a number of other futures exchanges were
established throughout the country in the decades
that followed. The Chicago Butter and Egg Board
was founded in 1898 and evolved into Chicago
Mercantile Exchange (CME) in 1919. Futures exchanges
also opened in Milwaukee, New York, St. Louis,
Kansas City, Minneapolis, San Francisco, Memphis,
New Orleans and elsewhere. Chicago, however,
became the most influential and predominant
location for futures trading in the U.S.
The Era of Financial Futures
Throughout the first seven decades of the twentieth
century, the futures industry remained essentially
as it had been – focused on the trading
of futures on agricultural products. But a remarkable
change occurred in the industry in 1971, with
the introduction of futures based on financial
products.
A New Concept: Futures on Foreign Currencies
Until 1971, world currencies had been pegged
to an international gold standard, but that
year the gold standard was abolished and currency
values were allowed to “float.” Leaders
of CME recognized that a currency whose value
was determined by market forces had become a
commodity like any other, and therefore futures
could be traded on it. There was (and still
is) an enormous forward market for currency
trading, but until then there were no exchange-traded,
standardized futures on currencies. As with
futures on agricultural commodities, currency
futures offered an opportunity to hedge against
risks in price changes, as well as to profit
from changes in values. That year, CME formed
the International Monetary Market (IMM), initially
a separate exchange closely linked to CME, and
hosted its first futures trades on foreign currencies.
The notion of trading futures on currencies
was highly controversial. But the concept garnered
credibility from the support of economist Milton
Friedman, who pronounced that the IMM would
“enable the world to operate more smoothly
and effectively.” Friedman proved correct,
and now currency futures have become an integral
part of international finance.
Interest Rate Futures
For many people it is one thing to understand
the agricultural futures markets and even currency
futures, but quite another to begin to imagine
futures on interest rates. Like agricultural
products and currencies, however, interest rates
– the price of money – vary according
to market pressures, and in this sense, they
can also be viewed as a type of commodity. Since
many businesses are subject to risk as rates
change, the futures industry reasoned that interest
rate futures could offer opportunities for hedging
against rising or falling rates or capitalizing
on rate changes, as did futures on other commodities.
CME launched its first interest rate product
in 1976 – a 90-day U.S. Treasury bill futures
contract – and over the next six years
it became CME’s most actively traded product.
CME then proposed trading futures on interest
rates paid for U.S. dollars on deposit overseas
– dubbed “Eurodollars” –
and again broke new industry ground by making
Eurodollar futures the first futures contract
which did not feature an actual or physical
delivery but rather used cash settlement. Cash
settlement eliminated the difficulty of physically
delivering interest obligations, such as Treasury
bills or notes, and thereby expanded the range
of products upon which futures could feasibly
be traded.
Stock Index Futures
Like currencies, interest rates, and crop prices,
stock index values also vary according to numerous
market pressures. Changes in index values can
positively or negatively affect businesses that
depend on them, such as mutual fund companies
and pension funds. Stock indexes, then, also
fit into the expanded definition of “commodity.”
In the early 1980s, stock index values had become
the barometers of overall health of the stock
markets, and stock index futures drew an immediate
audience because they enabled people to trade
the values of “the market” without
having to own any individual shares.
CME launched its first stock index futures
contract, the S&P 500® contract, in
1982. Stock index traders quickly learned that
they could use the futures markets to hedge
against falling prices and take advantage of
rising prices. When a market move took place,
traders could use index futures to either protect
their investments or increase their position
in the market without having to actually buy
or sell stocks. Stock index futures are also
appealing in that they are typically less costly
and easier to buy and sell than buying and selling
shares of hundreds or even thousands of stocks.
Quite clearly, trading futures on stock index
levels was a far cry from trading on live cattle
or corn. The futures industry, however, led
by the innovative thinking at CME, had learned
how to expand its markets and to meet the risk
management needs of our complex, post-agrarian
society.
What are futures?
Futures are contractual agreements made between
two parties through a regulated futures exchange.
The parties agree to buy or sell an asset -
livestock, a foreign currency, or some other
item - at a certain time in the future at a
mutually agreed upon price. Each futures contract
specifies the quantity and quality of the item,
expiration month, the time of delivery and virtually
all the details of the transaction except price,
which the two parties negotiate based on current
market conditions. Some futures contracts call
for the actual, physical delivery of the underlying
commodity or financial instrument at contract
termination. Others simply call for a cash settlement
at contract termination. Generally, however,
market participants do not hold their futures
contracts until termination but rather offset
futures contracts they have bought ("gone
long") by a subsequent sale; or, offset
futures contracts they have sold ("gone
short") by a subsequent purchase.
Futures contracts are also called derivatives,
because their value is derived from the market
value of the underlying commodity or financial
instrument on which the contracts are based.
Futures traded on exchanges regulated by governmental
agencies may be distinguished from derivatives
traded over-the-counter.
In broadest terms, futures are about anticipated
future prices of basic commodities and financial
instruments, based on current information. Futures
are concerned with such questions as what will
the price of cattle be next December? What will
interest rates be in six months? How much will
a euro be worth in May?
Because commodity prices are constantly changing,
virtually all businesses face ongoing price
risk. Meat processors face risk from fluctuating
cattle prices, lenders from changing interest
rates, and international businesses from varying
currency rates. All these businesses can use
futures to help manage their exposure to price
risk.
Futures contracts – price agreements –
are bought and sold in what is basically a marketplace
of opportunity for two symbiotic groups: hedgers,
who seek to offset price risk, and speculators,
who try to make a profit from favorable price
fluctuations. Hedgers are typically businesses
and financial institutions who buy and sell
futures contracts seeking to “lock in”
future prices for commodities that are essential
to their business operations. Speculators are
a diverse group that includes day traders, financial
institutions such as banks and hedge funds,
and arbitragers. These groups are brought together
at a futures exchange, which provides a venue
where their orders may interact on a trading
floor or a computer network, and where price
agreements can be negotiated.
Traders’ decisions generally aren’t
random, but are based on a synthesis of a great
deal of data and a variety of different strategies.
Some people make trading decisions based on
fundamental analysis of the forces of supply
and demand in a commodity market (“fundamental
analysis”); others trade based on an analysis
of market trends and price chart patterns (“technical
analysis”).
Because futures prices represent the aggregate
of all available information that may affect
the market, they are viewed as reflecting a
process of “price discovery.” Prices
change constantly in response to numerous factors,
ranging from weather and wars to political decisions
and popular trends. The futures markets assimilate
that information and provide a means of determining
the price above which buyers will not buy and
below which sellers will not sell – the
“equilibrium” price – where the
supply to be sold and the demand to buy are
in balance. The price of futures and the underlying
cash markets on which futures are based tend
to come together or “converge” by
contract expiration. The price of a futures
contract at expiration and the cash (“spot”)
price of the underlying asset must be the same,
because both refer to the same asset are basically
equivalent, because both prices refer to the
same asset.
What is a futures exchange?
A futures exchange, legally known in the U.S.
as a “designated contract market,”
is, at its core, an auction market – highly
regulated, technical and complex – but
an auction market nonetheless.
A futures exchange is the only place where
futures and options on futures (which offer
the right, but not the obligation, to buy or
sell an underlying futures contract at a particular
price) can be traded. Trading may take place
either on the exchange’s trading floor
or via an electronic trading platform. An exchange
itself does not trade futures. Instead, it:
* Provides and maintains the facilities where
buyers and sellers meet, ranging from traditional
“trading pits” to global electronic
trading networks
* Researches, develops and offers futures contracts
to be traded
* Oversees the trading of its products and enforces
trading-related rules and regulations
* Monitors and enforces financial and ethical
standards
* Provides daily and historical data on the
contracts traded under its auspices
Futures exchanges in the U.S. are subject to
a great deal of regulation. They are monitored
by the Commodity Futures Trading Commission
(CFTC) and the National Futures Association
(NFA). In addition, most futures exchanges practice
intense self-regulation, monitoring their employees
and the trading practices that occur in their
facilities.
These agencies look after the public interest,
ensure fair practice and monitor the process
of price discovery that occurs in futures trading.
Other governmental bodies, including the Securities
and Exchange Commission, the Federal Reserve
Board, and the U.S. Treasury Board also monitor
some futures exchange functions. Violations
of exchange rules can result in substantial
fines, as well as suspension or revocation of
trading privileges.
Futures Exchanges in the U.S. and Abroad
There are currently 13 futures exchanges registered
in the U.S. but not all are hosting active trading.
CME is the largest futures exchange in the U.S.
by volume, and the first U.S. futures exchange
to become a for-profit corporation, after revising
its original private membership structure and
a becoming publicly traded company in 2002.
Most U.S. exchanges remain not-for-profit, private
membership organizations, but a number of them
are actively weighing the advantages of changing
to stock corporations.
There are more than 50 futures exchanges worldwide,
and they are structured in a number of different
ways. Some futures exchanges are owned by groups
of banks or by a stock exchange holding company.
Other exchanges, or their holding companies,
are publicly listed on a stock exchange, similar
to CME.
How Futures Exchanges Earn Income
Since futures exchanges do not themselves engage
in trading, people sometimes wonder how they
earn money. Futures exchanges earn income primarily
by:
* Receiving a fee for every trade made through
the exchange.
* Selling price data – current, streaming
price data in real time as well as historical
price data on trades made through the exchange.
At CME, data subscription services include CME
E-quotes™ and CME E-history.
* Charging for clearing services, if the futures
exchanges own their own clearing house, as is
the case with CME. Some exchanges outsource
the clearing function. The Chicago Board of
Trade, for example, has its contracts cleared
through the CME Clearing House.
Types of Futures Traders
Hedgers
Hedgers are looking for some measure of price
certainty. Commodity hedgers – people who
trade agricultural products, energy products
or metals, for example – typically are
involved in commercial interests that either
produce, process or utilize the commodity they
are trading. Hedgers of financial futures are
typically in businesses that depend upon interest
rates, foreign exchange rates, or stock index
levels, such as banking or pension fund management.
Cattle ranchers, for example, may fear that
cattle prices will decline before they bring
their animals to market. To protect themselves,
they decide to sell futures on live cattle that
will expire at approximately the same time they
expect to deliver their cattle to the market,
and at the price they are hoping to get in the
cash market. If cattle prices do go down, the
ranchers can still make money on their futures
positions, that will hopefully offset the reduced
price they receive for their cattle.
Speculators
Speculators trade futures with the objective
of making a profit by being on the right side
of a price move. Since the prices of commodities
and financial instruments tend to change frequently,
at least in certain markets, trading opportunities
can be numerous.
Speculators can be categorized into several
broad groups: scalpers, day traders, position
traders, arbitragers, and people seeking exposure
to certain markets.
Scalpers typically trade for a small profit
on any single trade and therefore often trade
continuously, seeking to make as many small
gains as possible. In so doing, they create
liquidity – the presence of enough people
in the market so that market participants, notably
hedgers, can buy and sell quickly and in large
volume without substantially impacting prices.
Scalpers’ frequent trades increase the
trading possibilities available to others, and
help provide the liquidity that is essential
to the existence of futures markets.
Other speculators include day traders, who
typically make one or two trades per day, and
position traders, who tend to hold contracts
for days, weeks or months, depending on market
factors.
And finally, arbitragers are speculators who
watch the relative value of multiple markets
closely and step in to trade whenever momentary
price discrepancies appear. By keeping prices
in line for the same product trading on different
exchanges, arbitragers lend stability to the
price negotiation process.
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