They allow companies and individuals to protect themselves against fluctuations in the price of an asset that they are interested in. This allows them to sell an asset in advance giving them the ability to make plans for later in the knowledge that they have a fixed price.

They have been with us for a long time. Their first use can be traced back to 1650’s during the Tokugawa era in Japan. Feudal lords used to collect rents from their tenants in the form of rice.

Not only would they trade the rice that they had collected but also, they would often trade their future rice delivery.

This was the start of what became the Dojima Rice Market. Even today rice futures can be traded but the range of the market has expanded to include many other things.

For new traders the word FUTURES can be confusing as the word implies that everything takes place in the future. What actually happens is that the settlement takes place later but the price is agreed upon on that day (today).

It also important to realize that just because you bought it, does not mean that you have to keep it until settlement. You can sell the contract long before delivery of the contract is due.

Like many other markets you also do not need to necessarily own the asset before you sell it. You can sell a contract just as easily as you can buy it.

Because they have been around for such a long time nearly all its markets around the world are highly regulated.

The fundamental principle is fairly simple. You buy or sell something at today’s price for delivery at a future date. This can prove to be extremely valuable to farmers and organizations to protect themselves against fluctuations in price.

Let’s use a farmer for example. This allows him to sell his crop before it is harvested. In times when the harvest is plentiful and many other farmers with the same crop have had bumper harvest then there will be an over abundance of that crop. This will generally lead to a lower price.

In times when the harvest is bad and other farmers are also experiencing bad harvests the price will be high, as there is a limited supply of the asset.

There will however be times when it is very difficult to know when a crop will be good or bad and for the farmer this can be devastating in planning ahead.

One way he can overcome this is by selling his crop on the futures market at a price agreed upon today but only for delivery at a later date.

If he agrees on a price today and there is a very short supply of that crop on the agreed delivery date then the farmer may very well have been better waiting to deliver his crop at the market price.

It basically takes the uncertainty of the process away.

Futures contracts are generally divided into to distinct groups:

Financial assets such as a group of stocks, a market index or bonds.

Commodity asset such as coffee beans, wheat and pork bellies.

Why Would You Trade Futures?

There are three main reasons and they are:

Speculation – Many traders trade solely for the purpose of speculation. They have no intention to taking delivery of any assets but merely wish to speculate on the direction of the market.

Arbitrage – Is simply trying to make a profit by exploiting the difference in two different markets, If for example you though that the DJIA futures market was trading too high you might attempt to sell them and simultaneously buy the cash market.

Hedging – Hedging is common in both the commodities and financial assets. If you owned a portfolio of stocks and you thought that the market was about to correct but you still wanted to keep the stock, you might try to sell the market index of where the stocks were listed.

The Difference Between Cash and Futures Prices.

Because of the costs involved with the physical ownership of an asset such as storage and transportation the price between the cash market and the futures market differ. The difference in price is normally called the cost of ownership.

Ownership implies the cash market where you have additional costs, which leads to a difference between the cash price and the futures price where you don’t have these costs.

As the delivery date nears, the price difference will narrow and on actual delivery date the two prices will be very similar.

Exchanges

Chicago Board Of Trade (CBOT Established 1848 and founded by 82 Chicago Merchants)

Chicago Mercantile Exchange (CME Established 1919. Originally The Chicago Butter and Egg Board which was founded in 1898 which then developed into the CME)

London International Futures and Options Exchange (LIFFE Established 1982 and is now one of the world largest exchanges)

Remember this though: The same technical analysis applies to all securities...So you need to have a good trading plan if you hope to succeed trading this high yield security.

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