Futures Trading
Futures trading is a very important part of our daily lives and can be argued to be one of the more important industries in our modern day economy. It affects the lives of millions of people, even though most are not even aware of the influence it is having on their lives. From the clothes they wear to the food they eat and their finances and investments. All are affected in one way or another by futures trading.
Before the introduction of the Futures Markets, many people were either farmers or provided some type of service that directly complimented the farming industry. With the advent of the industrial revolution came the ability to produce more machinery and in turn more food. Our economic output was forced to keep pace with the explosive increase in our population and also in our standard of living. This increased level of productivity created the need for more efficient transportation, agricultural storage and a better means of distribution.
Prior to the introduction of futures trading all transactions were made in the cash markets. Simply put if a purchaser needed the goods they had to pay for it and take it with them. The problem that occurred was when the quantities increased the large purchasers needed to combine smaller pools of the Commodity to meet the ever-increasing demand. The problem with this was that there was no uniformity in the price, quality or in the manner of delivery. It was a nightmare for these large purchasers and was a very inefficient way to do business.
If the commodity wasn’t needed until a future date there was no way for the purchaser to protect himself against an increase in price. He in essence became a speculator. They had to either purchase the goods and store them for a future anticipated use or purchase the goods at a later date, hoping that the prices remained the same or were even lower. This was not an efficient way to do business because there was no way to protect profits. The same is true for the producer in that he had no way to protect himself against a decrease in the price.
The commodity futures markets answered these concerns by addressing the inherent problems of both the producers and the purchasers. The introduction of the futures markets standardized the market place by providing the following features:
1. Forward Pricing- The inherent risk of price fluctuation is always present until the goods are sold. The futures markets provided a way for each participant to determine the price far in advance because everyone knew the prices. The prices are determined based on supply and demand and allowed both the producer and purchaser the ability to hedge against an adverse price move.
2. Efficiency- The prices were readily determined through the large number of traders that were gathered in the pits. As more and more contracts were traded the liquidity of the market increased and so did the efficiency of the markets.
3. Easy Access- Anybody that needed to hedge against an adverse price move or anyone that was willing to speculate had an easily accessible place to do this.
4. Storability is not required- The futures markets also included instruments, which did not have to be stored. For example, stock indexes and Eurodollar time deposits are intangible and therefore can’t be stored.
So you can see that futures trading changed the way that we do business and allowed for a more stable business model by allowing each party to reduce their risk and lock in a predetermined profit. This risk was transferred to the speculator that for the most part was also looking to gain a profit by trying to determine the future price of a commodity.