What is the Futures Market and why would anyone want to trade it?
Wikipedia’s response is: A Futures Market is a financial exchange where people can trade Futures Contracts.Well, what is a Futures Contract? A Futures Contract is a legally binding agreement to buy specified quantities of commodities or financial instruments at a specified price with delivery set at a specified time in the future.
It is important to emphasize the word Contract. The first important difference between the Futures Market and, say, the Stock Market is that the Futures Market trades contracts, not shares of stock. You are not buying and selling a share (or piece) of a company. A Futures Contract is an agreement between investors to trade a specific quantity of a commodity or financial instrument, for example, gallons of gas or tons of wheat.
It is fairly simple to see how commodities work. An airline, for example, agrees to purchase 100,000 gallons of fuel for their planes at the current market price, but does not take delivery until sometime in the future.
That was why Southwest Airlines made money when the price of fuel was $140/barrel and other airlines had none. They had negotiated Futures Contracts with several oil companies years earlier when the price of oil was less expensive, and waited for delivery until 2007-2008. When the price of oil is cheap again, they’ll be buying Futures Contracts for delivery in 2011/2012.
That’s all well and good, you say, but that’s not really using a trading system with trading strategies, that negotiating.
For every Futures Contract, there is a degree of risk. Futures Contracts leverage risk against the value of the underlying asset.
Southwest acquired risk. If the price of crude fell below the price they paid, they paid more than they had to. Simultaneously, they reduced risk because they thought that the price of oil would go higher than their contract price. In their case, the leverage was profitable.
Now look at the oil companies. They reduced risk, believing crude oil prices would fall below the contract price they negotiated with Southwest. They acquired risk because the price of oil rose higher levitra orosolubile than the contract (thereby losing additional revenue they could have earned). In this case, their leverage was not as good as it might have been.
Here’s where you stop and say, I’m not Southwest Airlines. I’m an individual day trader. I don’t want to buy 100,000 gallons of crude. How can I trade Futures?
The Chicago Mercantile Exchange (CME), where the majority of Futures contracts are traded, realized that individual investors want to trade Futures just like major institutions; individual traders want to leverage their risk as well. They also understand that small investors will not risk millions of dollars on gallons of gas contracts or tons of wheat. Therefore, the CME decided to create an investment environment that would entice individual investors to trade Futures.
Remember, as small investor, you have lots of exchanges available to you for your trading day. You can invest in large cap stocks on the NYSE, tech stocks with the NASDAQ, ETFs – AMEX, and options at the CBOT. To entice investors to trade Futures, the CME created an exchange that made other exchanges pale in comparison.