Mechanics of the Futures Market – Overview

Study Notes:

The concept of a forward market is based on participants facilitating the purchase and sale of products that will not be produced, or won’t be available, until some specific time in the future.

In general, whether you’re a speculator willing to assume risk in order to make a profit, or you’re an investor who’s adopting a hedging strategy to protect a position, futures allow you to lock into prevailing prices.

The forward, or future price must take into account multiple factors that can influence the price of the product; and the structure of the end product, whether physical or purely financial, must be clearly specified in the contract, and, over many decades, exchange-traded futures contracts have grown into popular investment vehicles.

Any futures market is based on some underlying product, often a physical commodity, and offer producers or end-users the ability to hedge against adverse price movements in the value of the end product.

Some of the products available on global futures markets include metals such as gold and silver; energy-related products such as crude oil and natural gas; grains – such as corn, soybeans, and rice; soft commodities such as coffee, cocoa, sugar and frozen concentrated orange juice; as well as financial products, including interest rates, currencies and equity indices, among several others in each of these categories.

Sellers of these products may wish to lock into as high a price as possible to ensure they make at least a profit at the minimum, or at worst, that they cover the costs of production, while end-users may wish to hedge against rising prices in order to ensure a reasonable price for any commodity, and control as best they can, the costs they face.

And the more producers, buyers, sellers and hedgers that interact in any futures market, the more speculators are drawn in, creating additional liquidity, and generally improving market conditions.

In this module, we’ll introduce you to some of the risks faced by investors in the futures market, how certain of those risks are mitigated, as well as the difference between spot and forward prices, and contango and backwardation. We’ll also provide you with other insights about the mechanics of trading futures, including the roles of commoditized contracts, as well as margin requirements.