What is futures trading?

When we listen to the news we often hear comments like these: "June gold is trading at 806, or September crude oil closed at $40.75, down a dollar fifty". The average person knows that something related to financial matters is taking place, but does not understand precisely what is going on.

 

Exactly what is a future? A future is a contract to deliver a specified quantity of a specified commodity on a specific date in the future. Thus, on a futures exchange, the thing that is being traded is contracts. In the past, the term "commodity" referred to unfinished or semi-finished goods such as wheat, copper, gold and crude oil for example. In recent years the term "commodity" has been expanded to include such things as currencies, stock indexes and other things that bear little or no relationship to unfinished or semi-finished goods.

 

Why would anyone want to make a contract to buy or sell something at a future date? To answer this question, you must first understand that there are two kinds of futures traders, those who use the commodity in business and those who simply speculate in the price movement of the future.

 

Here is an example. In March of a certain year a farmer in North Dakota needs money to buy seed and pay for other expenses. His fields can easily produce twelve thousand bushels of wheat. At the same time, a flour mill needs ten-thousand bushels of wheat to make flour that will be produced in September. So the farmer sells two standard futures contracts to the flour mill for a certain price. Each contract requires the farmer to deliver five-thousand bushels of a certain type of wheat to a specified place on a certain date in September.  The farmer now has the money that he needs to pay for the crop and his expenses. The farmer is not concerned about what price he might receive for the crop when he harvest it in September. This is because the crop has been sold before he grew it. The flour mill has the wheat that it will need in September. The mill does not have to worry about what the price of wheat will be in September. The mill has already paid for the wheat that it needs in September. Even if the price of wheat doubles when September arrives the mill will still get ten-thousand bushels of wheat at the price that it paid for the futures contracts.

 

Speculators have no interest in producing or possessing the physical commodity. They are simply interested in making a profit on the price movement of the commodity. A speculator will buy the contract for September wheat at one price and (hopefully) sell the contract when he can make a good profit. All futures contracts have a date at which the physical commodity must be delivered. Therefore, a  speculator has a limited time in which to make his profit.

 

Speculators respond to changes in prices, not actual supply and demand of for a commodity. As a result, their activity often causes distorted prices in the futures markets. An good example of this was the sharp increase in the price of crude oil in the summer of 2008. The price peaked at about $147.00 per barrel before it began a sharp decline in price. Speculators had pushed the price of crude oil up to record highs. The actual price demanded by the users and consumers of crude oil was about $50 to $60 per barrel at that time. Soon the price fell to that level.

 

The role of speculators in the economy is the subject of much debate. Speculators do distort the market prices of commodities at times. But they also provide a market for commodities when there is little consumer demand. The wheat farmer we discussed at the start of this article needs money to plant his next crop. If a bakery will not by his crop, he can  sell this crop to a speculator instead. The speculator thus provides the money that the farmer needs to stay in business.