Understanding the fundamentals behind the futures industry is an important component for every new and aspiring futures trader to grasp.
To paint a clear picture of how futures trading has evolved into its current state, it’s helpful to review the definition of a futures contract and the origins of trading.
Origins of the Futures Contract
A futures contact is a standardized contract between a buyer and seller for the purchase or sale of financial instruments or physical commodities for future delivery on a regulated futures exchange. Traditionally, to exercise a futures contract, two conditions must be met.
- The buyer agrees to take delivery of the underlying product of the futures contract at the price it was bought.
- The seller agrees to deliver the underlying product of the futures contract at the price that it was sold.
Historically, this transaction took place at a futures market, also known as a cash or spot market, which offered a venue for the buyer and seller to meet and exchange a product for a cash transaction. These types of trading hubs and cities were established all throughout history in areas where both buyers and sellers would meet to exchange commodities and goods for on-the-spot delivery.
As negotiations from both buyers and sellers evolved, the cash forward transaction was born. Similar to a futures contract, a cash forward transaction is an agreement between the buyer and seller for a specified amount of a commodity to be delivered to a specific location at a later date. This transaction was the product of the buyer and seller negotiating the amount, quality of product and a timeframe for delivery. A distinguishable characteristic of a Cash Forward Transaction is its non-transferrable to a third party without consent from both the buyer and seller.
Trading Futures Contracts Through an Exchange
In today’s marketplace, buyers and sellers are matched and orders are filtered to a central location, aka, the exchange. Because futures contracts are standardized by a futures exchange, the quantity of the underlying product is a pre-defined amount:
- 5,000 Bushels of Wheat
- 1,000 Barrels of Crude Oil
- 100 Troy Ounces of Gold
New futures traders often wonder if the delivery of a commodity will come to fruition after a contract expires. Should one be prepared to securely store or deliver 1,000 of Crude Oil at contract maturity?
The short answer is no.
Brokerage Trade Desks closely monitor open positions nearing maturity and communicate with traders about liquidating the positions.
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