Today’s futures market has its origins in the agricultural markets of the 19th century. At that time, farmers began selling contracts to deliver their crops at a later date. This was done to anticipate market needs and balance supply and demand during the off-season.
The current futures market includes much more than agricultural products. It is a worldwide market for all kinds of commodities, including manufactured goods, agricultural products, and financial instruments such as currencies and treasury bills. A futures contract specifies what price will be paid for a product on a given delivery date.
When the futures market is played by speculators, the actual commodities are not important and there is no expectation of delivery. Instead, the futures contract itself is traded, as the value of this contract changes daily according to the market value of the commodity.
Each futures contract has a buyer and a seller. The seller takes a short position and the buyer takes a long position. A futures contract specifies a bid price, a quantity, and a delivery date. For example, A farmer agrees to deliver 1000 bushels of wheat to a baker at $5.00 per bushel. If the daily price of wheat futures falls to $4.00 per bushel, the farmer’s account is credited with $1000 ($5.00 – $4.00 X 1000 bushels), and the baker’s account is debited with the same amount. Futures accounts are closed every day.
At the end of the contract period, the contract is closed. If the price of wheat futures is still $4.00, the farmer has earned $1000 on the futures contract and the baker has lost the same amount. However, the baker now buys wheat on the open market at $4.00 per bushel – $1000 less than the original contract, so the amount lost on the futures contract is offset by the cheaper cost of wheat. Similarly, the farmer has to sell his wheat on the open market for $4.00 per bushel, which is lower than he anticipated when entering the futures contract, but the profit from the futures contract makes up the difference.
However, the baker is buying wheat at $5.00 per bushel and would have been able to buy wheat at $4.00 per bushel had he not entered the futures contract. He has protected himself against rising prices but loses if the market price falls.
Speculators hope to profit from the daily fluctuations in the futures market by buying long if they expect prices to rise (buyer) or buying short if they expect prices to fall (seller).
The foreign exchange market (FOREX) has several advantages over the futures market. FOREX is a more liquid market – as the largest financial market in the world, it eclipses the futures market in daily changes. This means that stop orders can be executed more easily and with less slippage on FOREX.
FOREX is open 24 hours a day, 5 days a week. Most futures exchanges are open 7 hours a day. This makes FOREX more liquid and allows FOREX traders to take advantage of trading opportunities as they arise rather than waiting for the market to open.
FOREX transactions are commission-free. Brokers make money by setting a spread – the difference between how much a currency can be bought for and how much it can be sold for. In return, traders have to pay a commission or brokerage fee for each futures trade they enter.
Due to the high trading volume, FOREX trades are executed almost instantly. This minimizes slippage and increases price certainty. Brokers in the futures market usually quote prices that reflect the last transaction – not necessarily the price of your trade.
FOREX is less risky than the futures market because of the built-in safeguards in the trading system. Debits in the future are always a possibility due to market gaps and slippage.