For nearly a century and a half, futures markets have fulfilled an important economic function: providing an efficient and effective mechanism for the management of price risks.
Beginning with agricultural futures contracts traded on the Chicago Board of Trade in 1865, the U.S. futures markets now list an everexpanding number of instruments, including metals, energy, financial instruments, foreign currencies, stock indexes, prediction markets and event futures. Additionally, the industry introduced trading in options on futures contracts in 1982.
Just as the types of instruments traded on futures exchanges have evolved, so has the method of trading those instruments. Until the 1990s, futures trading was conducted primarily on the floor of the exchanges.Traders crowded into trading “pits” or “rings”, shouting and signaling bids and offers to each other. This type of trading, known as open-outcry, resulted in competitive, organized price discovery.
In the 1990s, exchanges introduced electronic trading on certain contracts during offexchange hours. Since then, electronic trading has expanded to include side-by-side open outcry and electronic trading, as well as contracts that are exclusively traded electronically. Futures trading has truly become a 24 hours a day, seven days a week financial marketplace.
Participants in today's futures markets include mortgage bankers as well as farmers, bond dealers as well as grain merchants, lending institutions and individual speculators. By buying or selling futures contracts—contracts that establish a price level now for items to be delivered later— individuals and businesses seek to achieve what amounts to insurance against adverse price changes.This is called hedging.
Other futures market participants are speculative investors who accept the price risks that hedgers seek to avoid. Most speculators have no intention of making or taking delivery of the commodity. They seek instead to profit from a change in the price. That is, they buy when they anticipate rising prices and sell when they anticipate declining prices. The interaction of hedgers and speculators helps to provide active, liquid and competitive markets.
Speculative participation in futures trading has become increasingly widespread with the availability of alternative methods of participation. Whereas many futures traders continue to prefer to make their own trading decisions—such as what to buy and sell and when to buy and sell—others choose to utilize the services of a professional trading advisor, or to avoid day-to-day trading responsibilities by establishing a fully managed trading account or participating in a commodity pool which is similar in concept to a mutual fund.
For those individuals who fully understand and can afford the risks which are involved, the allocation of some portion of their capital to futures trading can provide a means of achieving greater diversification and a potentially higher overall rate of return on their investments. There are also a number of ways in which futures can be used in combination with stocks, bonds and other investments.
Speculation in futures contracts, however, is clearly not appropriate for everyone. Just as it is possible to realize substantial profits in a short period of time, it is also possible to incur substantial losses in a short period of time.
The possibility of large profits or losses in relation to the initial commitment of capital stems principally from the fact that futures trading is a highly leveraged form of speculation. Only a relatively small amount of money is required to control assets having a much greater value.As we will discuss and illustrate, the leverage of futures trading can work for you when prices move in the direction you anticipate or against you when prices move in the opposite direction.
The pages which follow are intended to help provide you with the kinds of information you should obtain—and the questions you should seek answers to—before making any decision to trade futures and/or options on futures.
Topics covered include:
- The regulatory structure of the futures industry
- How to conduct a background check of a futures firm
- How futures contracts are traded
- The costs of trading
- How gains and losses are realized
- How options on futures are traded
- How to resolve futures-related disputes
We have also included a Glossary at the back of this Guide for easy reference. In fact, we suggest that you become familiar with some of the terms included in the Glossary before continuing.
It is not the purpose of this Guide to suggest that you should—or should not—participate in futures and/or options on futures trading.That is a decision you should make only after consultation with your broker or financial advisor and in light of your own financial situation and objectives.
Finally, this Guide focuses primarily on exchange-traded futures and options on futures contracts. For information regarding off-exchange foreign currency (forex) futures and options, consult the NFA brochure “Trading in the Off- Exchange Foreign Currency Market: What Investors Need to Know.” The brochure is available free of charge on NFA's Web site (www.nfa.futures.org).