A futures contract is a commitment to make or take delivery of a specific quantity of a commodity or other financial obligation at a predetermined place and time in the future. All terms of the contract are standardized and established beforehand, except for the price, which is determined by open outcry in a pit or ring on the exchange trading floor of a commodity exchange. All contracts ultimately are settled either through liquidation (by offsetting purchases or sales) or by the delivery of the actual, underlying physical commodity. Delivery occurs in less than I percent of all contracts traded, however, as futures contracts are used primarily as financial instruments rather than as vehicles for the exchange of physical goods. The latter occurs in cash (also known as spot) markets instead.
Futures markets provide a medium in which persons or companies that are heavily dependent on prices of basic commodities, international exchange rates, or securities markets can reduce their exposure to adverse price swings. Known as hedging, this process can save companies millions of dollars they would otherwise lose in the cash markets when stock prices go down, foreign currencies lose value, and so forth. Other uses of futures markets include speculative investment and establishing a pricing environment for their underlying goods based on anticipated supply and demand.
In contrast to a futures contract, an options contract is the right, but not the obligation, to buy or sell a futures contract at some predetermined price at anytime within a specified time. Therefore, options give traders more flexibility than standard futures, but at an additional price for that luxury. If the holder of an options contract chooses not to exercise her right, she only pays a premium and does not have to complete the transaction. In a futures contract, the holder must either honor the terms of the contract or offset it by arranging a new contract.
Futures contracts are relatively new inventions, dating to approximately 1859, and have evolved alongside a similar mechanism known as a forward contract. Both originated out of the need for a reprieve from the sometimes harsh consequences of trading in cash markets. Forward contracts are agreements in cash markets between a buyer and seller of physical goods, such as a farmer's crops. Forward arrangements differ in specificity, but they are generally used to link a specific buyer to a specific seller at some point in the future when the physical goods are ready for delivery. A forward contract may or may not specify a price, and the parties can agree to set the price at delivery. This means that a forward contract can reduce risk for both the buyer and seller, but not with the same flexibility as a futures contract, which is normally completely divorced from the cash sale and delivery of an underlying product.
Futures trading was first regulated by the federal government in 1922, under the jurisdiction of the Grain Futures Administration, but it wasn't until 1974 that the modern regulatory agency, the Commodity Futures Trading Commission (CFTC), was established by Congress. The new agency brought with it reforms that greatly expanded the potential uses of futures markets. Until that time, futures were traded in the United States only on agricultural and mineral commodities. Beginning in 1975, the first contracts on financial instruments were offered, and by 1977 futures contracts on U.S. Treasury bonds were also available. Bond contracts later became the most widely traded futures in the world. Options on futures contracts were first offered in 1982.
Futures trading has been an attractive investment vehicle because of its low margins, high leverage, and frequently volatile prices. Futures offer investors the ability to buy or sell a contract for 5 to 18 percent of its underlying value. This leverage provides investors with a potentially high rate of return for a relatively small investment. However, substantial risk accompanies this potential for high rates of return. If the market moves in a direction contrary to the investor's position, he or she could lose the entire initial investment, as well as be liable for any additional losses that result from the adverse move. This reality has earned futures trading its reputation as one of the riskiest forms of investing.
When investors place orders to buy or sell futures contracts, they are required to post a performance margin, a payment to ensure that they fulfill their future financial obligations. Margins are set by the commodity exchanges on which the contract trades, but a brokerage firm, futures commission merchant, or introducing broker through which investors trade may require a larger margin than the exchange requires. The initial amount investors must deposit into their trading accounts is called the initial margin. On a daily basis, the margin is debited or credited to the investors' open position, based on the close of the day's trading session, known as marking-to-the-market. Investors must maintain a set minimum margin known as a maintenance margin. If their account equity drops below the maintenance margin, customers are required to restore the account to the initial margin level before they may buy or sell additional contracts. On the other hand, customers may withdraw any funds in the account which exceed the required margin.
In addition to low margins and leverage, futures markets provide the opportunity for an investor to profit from both price increases and decreases, depending on the kind of contract that is traded. If an investor buys a futures contract—known in the jargon as taking a long position—and prices rise, a profit can be made. Conversely, if a trader sells a contract—or goes short—and prices fall, there will also be a profit.
This dual nature suits futures trading especially well for hedging. Depending on a trader's relationship to the underlying commodity—a buyer or a seller in the simplest case—price movements mean different things. Buyers are concerned about insulating themselves from dramatic price hikes, whereas sellers wish to hedge in case prices bottom out. Futures contracts offer opportunities to do both things.
In fiscal 1997 more than 417 million futures contracts were traded on U.S. commodity or futures exchanges, according to annual figures released by the Commodity Futures Trading Commission. An additional 105 million options contracts were traded on U.S. exchanges that year. The Chicago Board of Trade and the Chicago Mercantile Exchange are by far the largest U.S. futures exchanges, together accounting for nearly 80 percent of all futures contracts traded in the country.
Chicago Board of Trade. A Chronological History. Chicago, 1998. Available from www.cbot.com .
Commodity Futures Trading Commission. Commodity Futures Trading Commission Annual Report. Washington, annual. Available from www.cftc.gov .
——. Economic Purposes of Futures Trading. Washington, 1997. Available from www.cftc.gov .