By David Adams
How do the Futures Markets Actually Function
People often consider futures markets very complex entities, when in fact they are fairly simple in principle. I will concede the technology required to operate an exchange is very complicated but the actual trading system is standardized and easy to understand.
A brief history of future exchanges might be in order, and they are far older than one might imagine. As far back as the thirteenth and fourteenth century wool was being sold in Europe via the futures contract. Parties would contract, even then, to purchase wool at a certain price and amount at a specified date in the future. Why? To guard against price fluctuations, which were an issue even in medieval economies, and they used reasonably sophisticated methodology to execute these transactions. The candlestick charts we often use have their history in sixteenth century Japan in the rice trading exchanges and some current day traders swear by the methodology of candlestick formations. The point is a simple one, futures exchanges have existed in some form for quite some time, and our current use of futures contracts are extensions of instruments pioneered quite some time ago.
By the nineteenth century, Chicago had become a center for agricultural commodities futures exchanges. Again, these exchanges allowed producers and warehouses to lock in prices and protect themselves against unwanted fluctuations. It should come as a bit of a surprise, then, that these institutions designed for hedge unwanted price fluctuations would become what we know them now as…centers of trade in financial products.
Why in the world did this happen?
The 1970s and 1980s saw drastic changes in the way international currency was managed and result saw wild fluctuations in individual currency worth and general currency market instability. The results of this dilemma are well documented, and we experienced double digit inflation and weak credit markets.
The answer was to standardize the trading of currency through the International Monetary Fund through the Chicago Mercantile Exchange, and in the mid 1980’s the first standardized S&P contract was introduced until we reach today, where there is a menagerie of financial indexes and international currencies to be traded, and all in a standardized form with specific terms of size and delivery. This did much to calm the international currency markets as a central clearinghouse now allowed hedging against potential loss due to currency fluctuations a reality.
But how do the exchanges actually work?
Think of the world’s largest auction and you can get a rough idea of how the futures market function. Though there are still some items that trade in the old style, though open outcry in a trading pit, the industry is gradually transitioning to electronic style trading where the market orders are matched through computers in a well defined sequence. Further, all trades clear through a clearing house, so the buyer or seller of a contract no longer has to worry about the stability of his/her counterpart, the clearing house assumes that responsibility with the assistance of intermediaries. Who are these intermediaries? They are the futures broker firms who are members of the clearing house and manage the margin accounts of the individuals buying and selling contracts. As any trader will tell you, margin is well managed and individuals are required to have on deposit the funds required to cover any potential losses in their trading activities. So you have a giant auction with people buying and selling contracts with the clearinghouse tallying the gains and losses for the day and the brokerage houses managing the margin accounts and executing the orders of individual traders. It is a very efficient system, and seems to improve with every passing year.
We have talked at length about the use of futures contracts to hedge against unwanted market price volatility, but there is one component we have not covered and that is the role of the speculator. The speculator has no interest in the underlying commodity on the contract he purchases or sells, he is interested in taking advantage of the price movement throughout whatever period of time he trades and hopes to profit. At first thought, this may seem a bit mercenary, but that would be an incorrect assumption. In order for the market to have a free flow of funds they must have a high degree of liquidity in the contracts traded and it is the speculator who provides this liquidity with his activities in the market. The average speculator trades at a far greater rate than a hedger, and thus there is a constant spin of money moving through the futures contracts. This liquidity is essential for the the futures market to function properly.
In summary, futures contracts provide stability of future prices and the attainment of good and stabilize the business market in the commodity being traded. In todays market there are futures market in oil, gold, stock indexes, currencies…the list is very long, and many of the futures contracts are extremely active. So there you have, the futures market is a large well regulated auction where price discovery and stability are achieved.
I am a long time retail and institutional trader who now only trades part time, usually in the morning. I enjoy writing informational articles about my style of trading so others may benefit. I endorse a state of the art trading program for beginners at Trading Concepts, Inc