Understanding the fundamentals of the futures industry is an important part that every new and aspiring futures trader should understand.
To paint a clear picture of how futures trading has evolved to its current state, it is helpful to review the definition of a futures contract and the origins of trading.
Origins of the futures contract
A futures contract is a standardized contract between a buyer and a seller for the purchase or sale of financial instruments or physical commodities for future delivery on a regulated futures market. Traditionally, to exercise a futures contract, two conditions must be met.
- The buyer agrees to receive the commodity underlying the futures contract at the purchase price.
- The seller agrees to deliver the underlying commodity of the futures contract at the sale price.
Historically, this transaction took place in a futures market, also known as a cash or cash market, which provided a venue where the buyer and seller met and exchanged a commodity for a cash transaction. These types of trading centers and towns were established throughout history in areas where buyers and sellers congregated to exchange products and goods to be delivered locally.
As the negotiations of buyers and sellers evolved, futures trading was born. Similar to a futures contract, a forward transaction is an agreement between buyer and seller for a specific quantity of a commodity to be delivered to a specific location at a future date. This transaction was the product of the buyer and seller negotiating the quantity, product quality and delivery time. A distinctive feature of a Cash Forward transaction is that it cannot be transferred to a third party without the consent of both buyer and seller.
Trading futures through an exchange
In today’s market, buyers and sellers are matched and orders are filtered to a central location, also known as an exchange. As futures contracts are standardized by a futures market, the amount of the underlying product is a predefined amount:
- 5,000 bushels of wheat
- 1,000 barrels of crude oil
- 100 troy ounces of gold
New futures traders often wonder if delivery of a commodity will occur after a contract expires. Do you have to be ready to safely store or deliver 1,000 barrels of crude oil when the contract expires?
The short answer is no.
Brokerage offices closely monitor open positions that are approaching expiry and communicate with traders about the liquidation of positions.
For more information on futures trading, bookmark the NinjaTrader blog.