What is futures trading? Well to understand this question, the easiest way is to look at the very beginning. Futures trading began around the 1840's in Chicago which by that time had become a trading and commercial center, linked to the east coast by telegraph and railroad lines.
With improvements in productivity and harvesting techniques, the city was full of farmers selling their grain and a class of professional traders emerged who would by the grain from the farmers and sell it to other markets. Exchanges grew up where this business could be carried out, and because of the lack of storage facilities and the huge surplus of grain in the city, traders could extract very low prices from the farmers for their produce. This was usually done with a 'spot' price, which meant cash paid for immediate delivery of the grain.
To avoid some of the hardships that this spot trading caused, farmers began to arrange future contracts, whereby they would agree to deliver a set amount of grain at a fixed date in the future for a fixed price. The system was therefore designed to bring security to the commodity suppliers and this is still the basis of future trading. However, it also provides huge potential for speculations from traders who can predict, or think they know, what the future prices of a commodity are likely to be.
For example, if you think a commodity, will be priced higher in the future, you can arrange a contract to buy it then, at a price similar to now. Likewise, if you think the price will be lower, you can arrange to sell then, at a price similar to now. If the market is expecting a certain future price, and you are expecting a different one, you can trade heavily on this. It is a high risk game but the potential gains are massive.
There are three requirements for a cash commodity to be traded on future contracts.
* It must be a standardized product with no difference between suppliers, and must be in a raw, unprocessed state. * If a good is perishable, it must have an adequate shelf life to facilitate trade. * There must be price fluctuations and uncertainty.
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