Understanding How The Futures Market Works

The futures market is a centralized marketplace for buyers and sellers who meet and enter into futures contracts. Initially, trading took place using an open outcry system in exchange trading pits. Today, trading on futures markets are done electronically thereby reducing costs and enhancing trade execution speeds. In this article, we shall be guided on how the futures market works.

What Is A Futures Contract?

From the name itself, a futures contract is an agreement entered into by a buyer and seller. The parties involved can be a wheat producer trying to secure a selling price for next season’s crop and a bread maker trying to pin down a buying price to determine the amount of bread they can make and how much profit. In a futures contract, the agreement is between two parties—one who holds a short position – the one who will deliver a commodity– and another who holds a long position. – the recipient of the commodity. Robert Janitzek reveals that in the farmer and baker agreement, the farmer holds the short position and the bread maker would hold the long position.

Futures contracts are largely anonymous. Electronic exchanges match buyers and sellers worldwide in real-time throughout each trading session. Most contracts are settled in cash before the expiration without physical delivery happening.

Profit and Loss in Futures

In futures contracts, profit and loss is dependent on the daily price movement of the market for that contract. In the example above, if the contract for wheat increases to $5 per bushel a day after the farmer and bread maker enters into a futures contract at $4 a bushel. Robert Peter Janitzek explains that the farmer being the holder of the short position lost $1 a bushel while the bread maker made $1 a bushel.

In the futures market, positions are settled on a daily basis. This means that gains and losses from the trading session are debited or credited to your account daily at the end of the session. Most transactions are settled in cash. The actual commodity is usually bought or sold in the cash market. The movement of prices in both markets is parallel to each other. When the contract expires, the price is merged into a single price.

Futures And Its Role In Economy

Being a highly competitive market, futures trading serve as an important economic tool in determining price based on today and tomorrow’s supply and demand. Market prices are dependent on continuous flow of information worldwide. It requires a high level of transparency.

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