Our modern futures market finds its beginnings in the agriculture markets of the 19th century. Back then, farmers would sell promises, or contracts, to deliver agricultural products at a later date. This was done to anticipate market needs, stabilizing supply and demand during off seasons, and assuring a steady flow of income for the farmer so he could purchase supplies and equipment as needed rather than having to wait for the gathering and sale of the crop.
In our modern era, the futures market
includes much more than agricultural products. It is a vast worldwide
market for all sorts of commodities including manufactured goods,
agricultural products, and financial instruments such as currencies and
treasury bonds. A futures contract will state what price will be paid
for a product at a specified delivery date.
When the futures market is played by
speculators, as it commonly is, 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 perceived market value of the commodity.
Every futures contract includes a buyer and
a seller. The seller takes the short position (i.e. sells something he
or she does not own), and the buyer takes the long position (in this
case, posession of an actual contract). The futures contract will
specify the buying price, the quantity and the 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.
Upon the end of the contract period, the
contract will be settled based on its terms. 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 had not entered into a
futures contract he would have been able to buy that wheat at $4.00 a
bushel. He has protected himself against rising prices but he will lose
if the market price drops.
Speculators hope to profit by these 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.
The FOREX Market
The foreign exchange market (FOREX) is considered to have several
advantages over the futures market.
FOREX is a much 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
(see glossary) in the FOREX.
The FOREX is open 24 hours a day, 5 days a
week, while most futures exchanges are only open 7 hours a day. This
adds to the liquidity of the market 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.
FOREX
Brokers earn their money by setting a spread – the
difference between what a currency can be bought at and what it can be
sold at. On the other hand, futures traders must pay a
commission or brokerage fee for each transaction they enter into.
Because of the high volume of trading, FOREX
transactions are executed almost instantly. This minimizes slippage
(see glossary) 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 considered 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.
