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The modern futures market brings together hedgers (grain producers, oil refineries, banks, etc.) seeking to offset cash market risk and speculators seeking to profit from price fluctuations in various physical commodities (grains, metals, energy products) and financial instruments (bonds, currencies, stock indexes). While investing in futures is often considered one of the most risky forms of investing, these markets have existed for hundreds of years. In my opinion, there is no question that only seasoned professionals who understand these markets ought to trade in them.

Unlike stock trades, where investors buy and sell actual shares in a company, futures transactions are contracts – agreements to buy or sell a particular commodity at a specified price sometime in the future.

The futures market can be traced back to ancient Greece and Rome, with organized trading appearing in Italy as early as the 10th century. By the 15th century, London, Amsterdam and Brussels were already major trading cities with a broad range of commodities being exchanged. They included grains, metals, wood, foodstuffs and cloth.

Besides cash transactions (or common spot) three contracts were in common use at the time:

To-Arrive Contract: Where the commodity was sold for delivery in a 10-to 60-day period. Similar to a cash sale, the seller must own what was being sold and convey title at the time of sale.

Forward Contract: Where the commodity was sold for delivery in 10 to 60 days, but title was not passed at the time of the sale. (Hence, the seller could sell something he did not yet own.)

Time Contract: Which was the same as a forward contract but deliverable beyond a 60-day period.

By the late 1500s, England was home to the Royal Exchange – the world’s first officially designated commodity exchange. London’s primary ranking as the world’s financial and commercial center in the 1700s had much to do with the long-term success of the Royal Exchange. The rapidly expanding commerce of Chicago in the mid-19th century became the primary catalyst for the development of the modern commodity exchange and the popularity of the trading of futures contracts.

In 1848, the Illinois State Legislature chartered the Chicago Board of Exchange in the United States. Eight years later, the notion of grades and standards was officially established at the CBOT, and by 1865 the Board passed its first rules on the subject of futures contracts. They provided for standardized delivery and margin deposits and prescribed terms of payments.

The last 20 years of the 1800s saw a huge growth in the futures arena, not only in the number of trading participants but in the scope of commodities being traded on various newly-formed exchanges. The effects of the Civil War on grain prices, coupled with surplus harvests and winter-time shortages, began to create huge price fluctuations and thus, very attractive profit situations for savvy players.

In contrast with traditional owner-oriented investors who took a real interest in the business in which they had purchased stock or made loans, these new futures speculators had very different views. They were there to take some of the price risk in return for reaping some of the profit. So began trading in which title and right was passed from one trader to the next with no intention of these investors receiving the actual goods. With farmers and processors now being joined by these speculators, the game took on a new meaning and taking delivery of a particular commodity was more the exception than the rule. This, then, became the true beginning of futures trading as we know it today.

Currently, there are less than 10 major futures exchanges in the U.S. with a combined yearly volume of more than 2.5 billion contracts. The contracts are traded in three major product areas: (1) commodity futures such as grain, metals, energy and livestock; (2) financial futures such as interest rates and foreign currencies, and (3) index futures – such as equity- and commodity-based indices.

Finally, the most important purpose of the futures market is to provide price insurance to those who produce or use certain commodities. In industry terms these people are called hedgers and include anyone who grows, produces or in any way handles a commodity for eventual sale. In essence most of these hedgers are trying to lock in a current price for a commodity into the future. Thus, mitigating the risk that the commodity will decline in price when these hedgers bring the commodity to market.

On the other side are speculators, trying to make money by buying contracts from the hedgers in hopes that they have guessed right on the underlying commodity’s price direction. If these speculators are right the value of the contracts they bought will go up and they can then sell them for a higher price. On the other, if they guess wrong, the contract price will decline and they will lose.

Quote of the Week: “A cynic is a man who knows the price of everything and value of nothing.”— Oscar Wilde.

Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.

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