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You are here: Home › knowledge center › About Futures
What is a Futures Contract
A futures contract is an obligation to buy or sell a commodity at or before a given date in the future, at a price agreed upon today. While the term “commodity” is usually used when referring to contracts like corn, or silver, it is also defined to include financial instruments and stock indexes. One of the benefits to the futures industry is that contracts are traded on an organized and regulated exchange to provide the facilities to buyers and sellers.
Exchange-traded futures provide several important economic benefits, but one of the most important is the ability to transfer or manage the price risk of commodities and financial instruments. A simple example would be a baker who is concerned with a price increase in wheat, could hedge his risk by buying a futures contract in wheat.
Not all futures contracts provide for physical delivery, some call for an eventual cash settlement. In most cases,, the obligation to buy or sell is offset by liquidating the position. For example, if you buy 1 S&P500 e-mini contract, you would simply sell 1 S&P500 e-mini contract to offset the position. The profit or loss from the trade is the difference between the buy and sell price, less transaction costs. Gains and losses on futures contracts are calculated on a daily basis and reflected on the brokerage statement each night. This process is known as daily cash settlement.
The 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.
An 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.
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.
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 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.
The Benefits of Futures Trading
Today, trading futures is without a doubt one of the most profitable financial investment instruments. There are in fact many advantages of futures trading, one of which is that it’s easy to learn within a relatively low time period. This low degree of difficulty makes futures trading that much more accessible and appealing to those without financial backgrounds.
Compared to other markets, the commission charges for futures trading are relatively small, and best of all are only paid after your trade had been executed and the fact that futures contracts are highly leveraged means that an investor can enter the market with a relatively small capital investment.
Consider some of the many advantages of trading the futures markets:
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