The origins of today's futures market lies in the agriculture markets
of the 19th century. At that time, farmers began selling contracts to
deliver agricultural products at a later date. This was done to
anticipate market needs and stabilize supply and demand during off
seasons.
The current futures market includes much more than agricultural
products. It is a worldwide market for all sorts of commodities
including manufactured goods, agricultural products, and financial
instruments such as currencies and treasury bonds. A futures contract
states what price will be paid for a product at a specified delivery
date.
When the futures market is played by speculators, the actual goods are
not important and there is no expectation of delivery. Rather, it is
the futures contract itself that is traded as the value of that
contract changes daily according the market value of the commodity.
In every futures contract there is a buyer and a seller. The seller
takes the short position and the buyer takes the long position. The
futures contract specifies a buying price, a quantity and a delivery
date. For example: A farmer agrees to deliver 1000 bushels of wheat to
a baker at a price of $5.00 a bushel. If the daily price of wheat
futures falls to $4.00 a bushel, the farmer's account is credited with
$1000 ($5.00 - $4.00 X 1000 bushels) and the baker's account is debited
by the same amount. Futures accounts are settled every day.
At the end of the contract period, the contract is settled. If the
price of wheat futures is still at $4.00 the farmer will have made
$1000 on the futures contract and the baker will have lost the same
amount. However, the baker now buys wheat on the open market at $4.00 a
bushel - $1000 less than the original contract, so the amount he lost
on the futures contract is made up by the cheaper cost of wheat.
Similarly, the farmer must sell his wheat on the open market for $4.00
a bushel, less than what he anticipated when entering the futures
contract, but the profit generated by the futures contract makes up the
difference.
The baker, however, is still in effect buying the wheat at $5.00 a
bushel, and if he hadn't entered into a futures contract he would have
been able to buy wheat at $4.00 a bushel. He protected himself against
rising prices but he loses if the market price drops.
Speculators hope to profit by the daily fluctuations in the futures
market by buying long (from the buyer) if they expect prices to rise or
by buying short (from the seller) if they expect prices to fall.
FOREX
The foreign exchange market (FOREX) has several advantages over the
futures market. FOREX is a more liquid market – as the largest
financial market in the world it dwarfs the futures market in daily
exchanges. This means that stop orders can be executed more easily and
with less slippage in the FOREX.
The FOREX is open 24 hours a day, 5 days a week. Most futures exchanges
are open 7 hours a day. This makes FOREX more liquid and allows FOREX
traders to take advantage of trading opportunities as they arise rather
than waiting for the market to open.
FOREX transactions are commission-free. Brokers earn money by setting a
spread – the difference between what a currency can be bought at and
what it can be sold at. In contrast, traders must pay a commission or
brokerage fee for each futures transaction they enter into.
Because of the high volume of trading FOREX transactions are almost
instantly executed. This minimizes slippage and increases price
certainty. Brokers in the futures market often quote prices reflecting
the last trade – not necessarily the price of your transaction.
The FOREX is less risky than the futures market because of built-in
safeguards in the trading system. Debits in futures are always a
possiblility because of market gap and slippage.
