Futures contracts are the original derivative, having been actively traded for literally decades. There are people that think the futures markets are nothing more than legitimized gambling. Not so – these markets serve a very real economic purpose. In this series of articles, we’re going to examine the purpose and the participants of these markets and various contract classes.
Price Discovery
Like any exchange or actively traded market, one of the primary purposes of the futures markets is price discovery. Unlike an over-the-counter dealer market, transparency is a major benefit of an exchange market. There is no mystery at what price level the market is trading at. The fundamental purpose of this price transparency is for market participants to have an efficient market as well as fair and competitive prices.
Leverage
The futures markets are an extremely leveraged market if measured by the value of the contract divided by the initial margin requirement. Some markets are more leveraged than others. For example, the foreign exchange markets are considerably more leveraged in that regard than the agricultural markets are. In addition, speculators must post higher margin than legitimate hedge accounts or exchange members and have higher maintenance requirements.
Contract Market
The futures are a contract market. That is, for every buyer, there has to be a seller. The resulting trade creates the contract. In essence, any contract market is a zero-sum game. The media driven hype about the recent rise in oil prices being driven by speculators was just that – hype. If you will notice, the media has been conspicuous by their absence in the subsequent decline in oil prices.
Market Participants
There are three basic groups that participate in this market; speculators, hedgers and market makers.
Legitimate hedge accounts use the futures market to hedge the value of the cash market commodity they have an interest in. In other words, if a hedge accounts owns, or is long, the cash market asset, the hedger would sell, or be short the futures contract. The result is that they more-or-less "lock-in" the price differential and as a result, hedge the price risk (not remove).
Speculators provide much of the liquidity, volume and open interest in any given market. This is a vital economic purpose as it gives the hedge accounts the liquidity and price efficiency they need.
Professional market makers make sure the markets stay price competitive and efficient. While these market makers have historically traded in the trading pits on the floor of the exchanges, recent times have seen an increasing emphasis on "upstairs" market making much like the fixed-income, foreign exchange and even over-the-counter equity markets have for years.
Suitability
Trading futures is not for the faint of heart – it is by definition, very risky business for speculators.
Hedge accounts tend to be institutional, whether they are energy companies, financial institutions or even farmers.
Speculators on the other hand should only participate in this market if they know what they are doing, have had a great deal of experience in other or kindred markets and should only use risk capital. In the futures markets, one can lose more than is originally invested. Proper and prudent cash management is particularly important.
Managed Futures
Many people and organizations are now looking at managed futures as a way to access this market but have their money be professionally managed by a Commodity Trading Advisor (CTA) or a Commodity Pool Operator (CPO). Never-the-less, one should be a "qualified investor" even with a professional managing the trading. By law, CTA’s and CPO’s must provide a Disclosure Document to potential investors.
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