Forex for Beginners courses : Basic Training2
Part 2
Part 2
Evolution of the Futures Markets
Trading in futures had its origin in the development of grain trading in the United States in the
mid-1800s.
The Japanese futures exchange began over a hundred years earlier than it did in the U.S. Their methods
of trading in the silk and rice markets, as well as the English methods of trading iron warrants, were
precedents to the United States futures markets.
The practice of futures trading in the United States evolved naturally from the need to protect against
volatile price moves in physical grain products. Chicago took the leading role as the center of grain
futures trading.
The Midwest is the heart of a rich and vast agricultural region and, since Chicago is strategically
situated as a shipping center, it was a natural site for grain trading. The Mississippi River and its
tributaries were available to move grain and later, in conjunction with the railroads, commerce in the
grain markets flourished.
The Chicago Board of Trade was organized in 1848 and actually began trading about 1859. It was
formed to meet the needs of producers (farmers) and exporters in order to systematically manage their
risk and exposure to unknown elements such as weather, political events and economic uncertainty.
The concept of hedging, upon which the futures markets are based, became widely used and continues
today to serve as a valuable tool for risk management.
What Is Hedging?
The concept of hedging is based upon the assumption that movement in cash and futures prices will
parallel each other in movement after due allowance has been made for any seasonal or other trend in
the cash market.
In essence, the goal of the hedger is to lock in an approximate future price in order to eliminate his risk
of exposure to interim price fluctuations. The best way to understand hedging and the futures market
is by example. I will assume that you have no understanding of the futures market.
Suppose You are a Grain Farmer
It becomes hot and dry. Rain is scarce in most parts of the country, and some of the large
grain-processing firms become concerned about what will happen to corn prices several months in the
future as the heat and drought damage take their toll on the crop.
In your area however, weather is fine. You grow corn. Your crop has been planted and the summer has
not been too bad and moisture has been sufficient. Your crops are quite good, in fact.
The grain-processing concerns such as large baking companies, animal feed manufacturers, food
processors, vegetable oil producers and other related concerns begin to buy corn from farmers and
grain firms who have it in storage from previous years. Their buying is considerable due to their
immense needs. Simple economics tells us that the price of corn will rise as the supply falls.
Prices begin to rise dramatically in what is called the ‘cash market.’ This is the immediate or day-to-
day market. Another term for the cash market is the ‘spot market.’ It is so termed because it refers to
transactions made on the spot, that is, for immediate delivery, not for delivery at some point in the
future.
Assume that you know the cost of production for your corn. In other words, you’ve taken into
consideration your fertilizer, fuel, land, labor and additional costs. You conclude that it costs you
$1.85 to produce each bushel of corn.
Your call to the local grain terminal -- where cash corn is bought and sold -- tells you that today cash
corn is selling for $3.25 per bushel. You know that only two weeks ago it was at $3.00 per bushel and
three months ago it was going for $2.75.
You know you will be producing over 50,000 bushels of corn this year and, as a consequence, the price
difference between what the market was several months ago and today’s price is considerable. In fact,
it runs into thousands of dollars.
What are Your Options?
You know that by the time your crop has been harvested, prices may be back down again.
What could force prices back down?
Many things could happen. The government could release grain from its reserves to drive prices down;
foreign production could be larger than expected making the U.S. crop reduction less important or
weather could improve significantly, lessening the impact of the problem. Demand could decline and
the grain companies might sell from some of the supplies they’ve accumulated.
Regardless of what actually happens, you’ve decided that you want to sell your crop at the current
price.
You Can Do Either of Two Things
You can enter into a forward contract with a grain firm.
This contract is made between you and a grain processor or elevator. (These firms are
known as ‘commercials’.)
They will quote you a price for your crop to be delivered to them at some point in the
future, usually shortly after harvest. Often, their price is not as high as the market’s
current trading level. Or,
As an alternative, you could sell your crop on the futures market.
The futures markets are organized exchanges or marketplaces where many individuals
congregate for the purpose of buying and selling contracts in given markets for future
delivery and/or for speculation.
Prices there will be relatively free of manipulation by large commercial interests, which
may have almost complete control over what you will be paid in your hometown area for
your crop. Provided your corn meets the proper exchange specifications, you can sell it
in advance on the futures exchange.
You will not get your money until the crop is delivered to the buyer, but the price you get
will be locked in. Regardless of where the price goes thereafter you will be guaranteed
the price at which you sold your crop
You Could Win or Lose
If the cash market is higher by the time the crop is ready, you will not make as much as you might have.
If the price is lower, then you are fortunate to have sold prior to the decline.
Of course, you have the option of doing nothing, hoping that corn will be much higher at some point in
the future.
The essence of the futures market vehicle is, its use as a tool by which the producer and end-user can
hedge or protect profits.
Futures are ideal hedges against rising or falling prices.
What’s in it for the Players?
Who takes the other side of the futures transaction and why? In other words :
• Who will buy the grain from you?
• Why will they buy it?
• What will they do with it?
• How will they sell it if they change their mind?
Part 2 End
Trading in futures had its origin in the development of grain trading in the United States in the
mid-1800s.
The Japanese futures exchange began over a hundred years earlier than it did in the U.S. Their methods
of trading in the silk and rice markets, as well as the English methods of trading iron warrants, were
precedents to the United States futures markets.
The practice of futures trading in the United States evolved naturally from the need to protect against
volatile price moves in physical grain products. Chicago took the leading role as the center of grain
futures trading.
The Midwest is the heart of a rich and vast agricultural region and, since Chicago is strategically
situated as a shipping center, it was a natural site for grain trading. The Mississippi River and its
tributaries were available to move grain and later, in conjunction with the railroads, commerce in the
grain markets flourished.
The Chicago Board of Trade was organized in 1848 and actually began trading about 1859. It was
formed to meet the needs of producers (farmers) and exporters in order to systematically manage their
risk and exposure to unknown elements such as weather, political events and economic uncertainty.
The concept of hedging, upon which the futures markets are based, became widely used and continues
today to serve as a valuable tool for risk management.
What Is Hedging?
The concept of hedging is based upon the assumption that movement in cash and futures prices will
parallel each other in movement after due allowance has been made for any seasonal or other trend in
the cash market.
In essence, the goal of the hedger is to lock in an approximate future price in order to eliminate his risk
of exposure to interim price fluctuations. The best way to understand hedging and the futures market
is by example. I will assume that you have no understanding of the futures market.
Suppose You are a Grain Farmer
It becomes hot and dry. Rain is scarce in most parts of the country, and some of the large
grain-processing firms become concerned about what will happen to corn prices several months in the
future as the heat and drought damage take their toll on the crop.
In your area however, weather is fine. You grow corn. Your crop has been planted and the summer has
not been too bad and moisture has been sufficient. Your crops are quite good, in fact.
The grain-processing concerns such as large baking companies, animal feed manufacturers, food
processors, vegetable oil producers and other related concerns begin to buy corn from farmers and
grain firms who have it in storage from previous years. Their buying is considerable due to their
immense needs. Simple economics tells us that the price of corn will rise as the supply falls.
Prices begin to rise dramatically in what is called the ‘cash market.’ This is the immediate or day-to-
day market. Another term for the cash market is the ‘spot market.’ It is so termed because it refers to
transactions made on the spot, that is, for immediate delivery, not for delivery at some point in the
future.
Assume that you know the cost of production for your corn. In other words, you’ve taken into
consideration your fertilizer, fuel, land, labor and additional costs. You conclude that it costs you
$1.85 to produce each bushel of corn.
Your call to the local grain terminal -- where cash corn is bought and sold -- tells you that today cash
corn is selling for $3.25 per bushel. You know that only two weeks ago it was at $3.00 per bushel and
three months ago it was going for $2.75.
You know you will be producing over 50,000 bushels of corn this year and, as a consequence, the price
difference between what the market was several months ago and today’s price is considerable. In fact,
it runs into thousands of dollars.
What are Your Options?
You know that by the time your crop has been harvested, prices may be back down again.
What could force prices back down?
Many things could happen. The government could release grain from its reserves to drive prices down;
foreign production could be larger than expected making the U.S. crop reduction less important or
weather could improve significantly, lessening the impact of the problem. Demand could decline and
the grain companies might sell from some of the supplies they’ve accumulated.
Regardless of what actually happens, you’ve decided that you want to sell your crop at the current
price.
You Can Do Either of Two Things
You can enter into a forward contract with a grain firm.
This contract is made between you and a grain processor or elevator. (These firms are
known as ‘commercials’.)
They will quote you a price for your crop to be delivered to them at some point in the
future, usually shortly after harvest. Often, their price is not as high as the market’s
current trading level. Or,
As an alternative, you could sell your crop on the futures market.
The futures markets are organized exchanges or marketplaces where many individuals
congregate for the purpose of buying and selling contracts in given markets for future
delivery and/or for speculation.
Prices there will be relatively free of manipulation by large commercial interests, which
may have almost complete control over what you will be paid in your hometown area for
your crop. Provided your corn meets the proper exchange specifications, you can sell it
in advance on the futures exchange.
You will not get your money until the crop is delivered to the buyer, but the price you get
will be locked in. Regardless of where the price goes thereafter you will be guaranteed
the price at which you sold your crop
You Could Win or Lose
If the cash market is higher by the time the crop is ready, you will not make as much as you might have.
If the price is lower, then you are fortunate to have sold prior to the decline.
Of course, you have the option of doing nothing, hoping that corn will be much higher at some point in
the future.
The essence of the futures market vehicle is, its use as a tool by which the producer and end-user can
hedge or protect profits.
Futures are ideal hedges against rising or falling prices.
What’s in it for the Players?
Who takes the other side of the futures transaction and why? In other words :
• Who will buy the grain from you?
• Why will they buy it?
• What will they do with it?
• How will they sell it if they change their mind?
Part 2 End
