How the Futures Market Works - Understanding the Logic
Assume that you are a farmer who plants corn and I am an entrepreneur who runs a flour mill. The current price of corn is $4 a bushel. For you to make a decent price, you need to sell your corn at the highest price. For my flour mill to do good, I need to buy corn from you at the lowest price. That’s how a real market economy works.
Unfortunately, no one can accurately predict the future price of corn. Yes, we might have the historic data but that does not work all the time. For instance, sometime later there might be a locust attack which no one predicted. So, to cushion you from making a loss, I might come and promise to buy your corn at $4.5 a bushel in the next season.
The logic behind this is that in the next season, the price of corn could fall to $3.7 a bushel. If this happens, then you will make a loss. With my guaranteed $4.5, you will be at peace. Alternatively, the price of corn could rise to $4.7 a bushel. This will make it so expensive for me which will impact my profit margins. The future contact will therefore protect the two of us. In short, that’s how the futures market works.
⇒ See also How to Trade Futures
Futures Market for Traders
As a trader, it is very important to have the idea about the Futures definition. This is because advanced traders use the future prices to make trading decisions. While We don’t actively trade the futures market, We are active user of the data got from the futures market. For instance, if investors have priced in the next month’s price of oil at $55 a barrel, chances are that the spot price of oil will move up. The correlation between the spot and future price is almost perfect.
The futures market has been in existence for centuries. However, the first formal futures market was established in 1850s in the Chicago Board of Trade. This is one of the biggest futures trading company in the world. Today, other exchanges have been established with the main ones being ICE and Euronext. In many small countries, the futures market has been established too. The futures market was primarily established for the commodities market.
However, as the market has become sophisticated, this has led to new trading instruments being introduced. For instance, now we have the futures market for currencies, equities, and even indices. A trader who has a deep understanding of the futures market is likely to make better trading decisions. To make trading decisions, you need to understand the factors that influence the future price of an instrument.
For example, in the corn market, the factors could be the following.
- One, the weather as predicted by forecasters has an important role to play. If it is estimated that the amount of rainfall expected in corn growing areas is enough, chances are that the future price will be lower because of the expected supply.
- The growth or stagnation of the Chinese economy is another factor. If the economy expands faster than expected, it means the demand of corn could be more. This will lead to a higher price. These are some of the underlying movers of the futures market.
Hedging - The most Helpful use of Futures Market
The main role played by the futures market is hedging. The reason why a farmer can price in the next harvest is to protect himself from a downturn in the market price. We have just written a lot about hedging and why its of a lot of importance for traders. It prevents you from making excess losses.
Hedging involves looking at an instrument and comparing it with another instrument. For instance, you can look at the price of oil and compare it with that of the dollar. Normally, if the price of oil strengthens, chances are that the dollar will weaken. Therefore, you can use the futures market of oil to put an appropriate price on the price of the dollar.