Most trader’s early introduction to futures probably came from the unlikely source of Eddie Murphy in the film ‘Trading Places’. You may remember people in oddly coloured golfing jackets madly yelling and signaling to one another about such obscure things as pork bellies, lumber and orange juice. All exciting stuff!
Whilst it might be tempting to think that futures trading is a recent invention, futures trading actually predates organised equities trading. Since futures are a form of forward delivery or promissory note, primary producers have been using them in one form or another for several hundred years. Japanese rice producers had a type of futures contract several hundred years ago to smooth out fluctuations in the prices they received for their crops.
The first organized grain futures trading in the United States began in places such as New York City and Buffalo, but the emergence of what we would recognize as a modern futures contract occurred in Chicago in the 1840s. With the construction of the railroads, Chicago began to emerge as a centre for transportation between producers and East Coast population centres. Thus Chicago was a natural Mecca for traders, but the trading that took place there was inefficient and disorganised until a group of Chicago-based businessmen formed the Board of Trade of the City of Chicago in 1848. The Board was a member-owned organization that offered a centralized location for cash trading of a variety of goods as well as trading of forward contracts. Members served as brokers who facilitated trading in return for commissions.
As trading of forward contracts (early individualized futures contracts) increased, the Board began the process of standardizing contracts – a move that would streamline the trading and delivery processes. Instead of specific individual contracts which were inefficient and time consuming, traders were asked to deal contracts that were identical in terms of quantity, quality, delivery month and terms. It is these features of standardisation that allows futures markets to function as effective hedging instruments.
Until twenty years ago, futures markets consisted of only a few agricultural products, however as markets have matured, these agricultural commodities have been joined by an array of additional products.
The table below gives some idea of the breadth and scope of futures markets.
All futures contracts are standardised in terms of the quantity, quality and delivery month. For example the table below shows the contract specifications for the SFE SPI 200 Index Futures Contract.
Let’s get into the specifics
Using the details from the contract specification table we can look an example trade. Let’s assume that we are bullish the index and it is currently trading at 6300 points, so we purchase a single contract at 6300 points. Some time in the future the index has moved to 6400 points and we close out our contract – our profit on the trade is 100 points multiplied by $25 per point or $2,500. This example displays the feature of leverage that draws many traders to futures markets. However leverage works both ways if our position had lost 100 points we would have incurred a loss of $2,500.
Financial futures also enable traders to take a position that replicates the underlying index without having to purchase all the shares in the index in their correct weightings. When you buy the SPI contract by definition you are holding a surrogate portfolio that represents all the underlying shares in the index. The value of this portfolio is easy to calculate – it is the current value of the index multiplied by $25. So if the index is at 6300 and you are long the SPI you have a portfolio worth $157,500. This portfolio replication also demonstrates why hedgers find futures markets attractive.
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