Futures Market Essentials and How They Work

The anonymity of tomorrow controls the market value of goods and services. And as a result of this unknown factor X, the futures market emerged. In this article, you’re going to learn more about futures market and stock futures market.

Brief history

Japan pioneered the foremost official futures trading market in 1710. The emergence of such exchange was necessary, to ensure a more efficient market for rice sellers and buyers. Unlike Japan, the earliest traded futures contract in the states is corn.

By default, futures markets were orchestrated to bring producers and end-users of raw materials together. But nowadays, futures market is used globally for agricultural produce and others goods such as – currencies, metals, energy and financial tools.

What is Futures Contract

A futures contract is best defined as an agreement to trade an underlying commodity at a specific time and fee. There’s a specific volume of commodity associated with a futures contract for instance – crude oil has a contract unit of 1,000 barrels while corn, on the other hand, has a unit of 5,000 bushels.

How Futures market Works

The futures exchange has a basic function of connecting buyers and sellers buyers and sellers with the intent of signing a futures agreement. Unlike the open outcry system used by conventional trading market, futures market is operated with e-trading systems that decrease costs and improve trade execution speeds.

Most futures contracts are cash settled and halts with no physical delivery of the goods for instance – a good that has been secured in the time frame of 12 months automatically loses the opportunity of selling above the agreed price. This agreement is a risk-absorber that reduces the chances of paying a higher fee for a commodity.

Since an agreement has been struck between the buyer and seller, it’s the futures contract that can be purchased not the commodity. The futures market has two positions; the short position and the long position. The short position is held by the agreed deliverer of the goods while the long position is occupied by the receiver of the commodity. In the case of wheat futures trade, the farmer would hold the short position and the breadmaking company would hold the long position. On the other hand, when no physical commodity is involved, for example – a stock futures contract – investors are given these positions, according to their side of trade.

Note: Almost every futures contract is settled with money prior the contract’s expiry date, with no physical delivery happening.

Futures exchange Cash Settlement

The futures market operates on predictions and is determined by fluctuations of market value of the contracts. Let’s say the futures contract for corn jumps to $10 per barrel a month after a farmer and buyer enter into their futures contract at $9 per barrel. The farmer loses $1 per barrel by default because the selling price just increased from the price at which he agreed to exchange his corn. The receiver gains $1 per barrel because the price he agreed to pay is less than what the rest of the market is compelled to pay in the future for corn.
The moment this price change is experienced, the deliverer loses $1 per barrel and the  gains $1 per barrel. These sort of changes happen usually, in the futures market, from time to time. Even though the accounts of each party is debited according to these changes, the profit or loss is only realised when the futures stock is sold before the expiry date.

It’s important to note that the profits and gains in future markets are placed against one another. But merges  into one price, when the contract expires.

Economic relevance of the Futures Market

The market has proven itself to be highly competitive. The exchange is quite useful in the determination of prices of goods based on pure financial estimation. The market is controlled by an unstopping flow of data, researches and opinions globally, which are founded on clarity. Different conditions such as climate, social upsurge, debt default, refugee displacement, land reclamation and deforestation can affect supply, demand, and future price of a commodity.

Investors also consider futures market when they aim at limiting their risks while purchasing a commodity. The pre-set nature of the price shields their interests by informing the other party of the price before a particular date. Reduction of cost, with lesser risk is the main benefit. Since there is little or no probability that the other party would raise prices to make up for any financial losses in the cash market.

Final thoughts

The futures market is another proof that the fate of our economy is being influenced by changes in speculated prices. From the bread we eat to the cotton we wear, as investors and consumers, we need to learn how to take control of this unknown the X factor.