THE     FUTURES     MARKET


INTRODUCTION
What we know as the futures market of today came from some humble beginnings. Trading in futures originated in Japan during the 18th century and was primarily used for the trading of rice and silk. It wasn't until the 1850s that the U.S. started using futures markets to buy and sell commodities such as cotton, corn and wheat.
A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something, for a set price, that is not deliverable until a future date. But participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities. Traders in the futures market primarily enter into futures contracts to hedge risk or speculate rather than exchange physical goods. The cash (spot) market is where producers exchange physical goods. Futures are used as financial instruments which to eventually tend to parralell the price movement of the underlying cash market.
The consensus in the investment world is that the futures market is a major financial hub, providing an outlet for intense competition among buyers and sellers and, more importantly, providing a center to manage price risks. The futures market is extremely liquid, risky, and complex by nature, but it can be understood if we break down how it functions.
While futures are not for the risk-averse, they are useful for a wide range of people. A common denominator among all futures contracts, is the need for hedging the underlying commodity.
  

HISTORY
Before the North American futures market originated some 150 years ago, farmers would grow their crops and then bring them to market in the hope of selling their inventory. But without any indication of demand, supply often exceeded what was needed, and unpurchased crops were left to rot in the streets. Conversely, when a given commodity, such as grain, was out of season, the goods made from it became very expensive because the crop was no longer available.
In the mid-19th century, central grain markets were established and a central marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (spot trading) or for forward delivery. The forward delivery contracts were the forerunners to today's futures contracts. In fact, this concept saved many a farmer the loss of crops and profits and helped stabilize supply and prices in the off-season. An important distinction between forward contracts and futures contracts is contract spefication. Specifications for all futures contracts for a particular commodity are the same, except for price. Forward contracts could have varying specifications, such as size, quality, and delivery date.
As the agriculture commodities dominated the futures markets for over 100 years, financial contracts, such as foreign currencies, treasuries, and stock indices were introduced in the 1970's and 1980's, and have dominated the futures industry ever since.
 

HOW IT WORKS
The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically. The futures contract will state the price that will be paid and the date of delivery. But don't worry, as we mentioned earlier, almost all futures contracts end without the actual physical delivery of the commodity
A futures contract is an agreement between two parties: a short position, the party who agrees to deliver a commodity, and a long position, the party who agrees to receive a commodity.
In every futures contract, everything is specified. The quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The price of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future.
Profit And Loss - Open Trade Equity
The profits and losses of a futures depend on the daily movements of the market for that contract and is calculated on a daily basis. For example, say the futures contracts for wheat increases 10 cents per bushel the day after a trade is made. (Each cent change is equal to $50.00).
On the day the change occurs, the seller's account is debited $500 (10 cent x $50), and the buyers account is credited $500. As the market moves every day, these kinds of adjustments are made accordingly. Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day. In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides to sell the stock or cover his or her short position.
As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market. Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. So on the date either party decides to close out their futures position, the contract will be settled.
A futures contract is really more like a financial position. You can see that the two parties in the wheat futures contract discussed above could be speculators or hedgers. If a speculator, the profit or loss is treated as a short-term capital gain. If a hedger, the gain or loss would offset the change in value of the underlying physical commodity.
 

THE PLAYERS

Hedgers
Farmers, manufacturers, importers and exporters can all be hedgers. A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks.
The holders of the long position in futures contracts (the buyers of the commodity), are trying to secure as low a price as possible. The short holders of the contract (the sellers of the commodity) will want to secure as high a price as possible. The futures contract, however, provides a definite price certainty for both parties, which reduces the risks associated with price volatility. Hedging by means of futures contracts can also be used as a means to lock in an acceptable price margin between the cost of the raw material and the retail cost of the final product sold.
Speculators
Other market participants, however, do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. These are the speculators, and they aim to profit from the very price change that hedgers are protecting themselves against. Hedgers want to minimize their risk no matter what they're investing in, while speculators want to increase their risk and therefore maximize their profits. The speculator is vitally important as they help provide the liquidity that the hedger needs.
In the futures market, a speculator buying a contract low in order to sell high in the future might be buying that contract from a hedger selling a contract low in anticipation of declining prices in the future.
Unlike the hedger, the speculator does not actually seek to own the commodity in question. Rather, he or she will enter the market seeking profits by offsetting rising and declining prices through the buying and selling of contracts.
 

REGULATION
The United States' futures market is regulated by the Commodity Futures Trading Commission (CFTC), an independent agency of the U.S. government. The market is also subject to regulation by the National Futures Association (NFA), a self-regulatory body authorized by the U.S. Congress and subject to CFTC supervision.
A broker and/or firm must be registered with the CFTC in order to issue or buy or sell futures contracts. Futures brokers must also be registered with the NFA and the CFTC in order to conduct business. The CFTC has the power to seek criminal prosecution through the Department of Justice in cases of illegal activity, while violations against the NFA's business ethics and code of conduct can permanently bar a company or a person from dealing on the futures exchange. It is imperative for investors wanting to enter the futures market to understand these regulations and make sure that the brokers, traders or companies acting on their behalf are licensed by the CFTC.
In the unfortunate event of conflict or illegal loss, you can look to the NFA for arbitration and appeal to the CFTC for reparations. Know your rights as an investor!