Introduction
For nearly a century and a half, futures markets have fulfilled an important economic function: providing an efficient and effective mechanism for the management of price risks.
Beginning with agricultural futures contracts traded on the Chicago Board of Trade in 1865, the U.S. futures markets now list an everexpanding number of instruments, including metals, energy, financial instruments, foreign currencies, stock indexes, prediction markets and event futures. Additionally, the industry introduced trading in options on futures contracts in 1982.
Just as the types of instruments traded on futures exchanges have evolved, so has the method of trading those instruments. Until the 1990s, futures trading was conducted primarily on the floor of the exchanges.Traders crowded into trading “pits” or “rings”, shouting and signaling bids and offers to each other. This type of trading, known as open-outcry, resulted in competitive, organized price discovery.
In the 1990s, exchanges introduced electronic trading on certain contracts during offexchange hours. Since then, electronic trading has expanded to include side-by-side open outcry and electronic trading, as well as contracts that are exclusively traded electronically. Futures trading has truly become a 24 hours a day, seven days a week financial marketplace.
Participants in today's futures markets include mortgage bankers as well as farmers, bond dealers as well as grain merchants, lending institutions and individual speculators. By buying or selling futures contracts—contracts that establish a price level now for items to be delivered later— individuals and businesses seek to achieve what amounts to insurance against adverse price changes.This is called hedging.
Other futures market participants are speculative investors who accept the price risks that hedgers seek to avoid. Most speculators have no intention of making or taking delivery of the commodity. They seek instead to profit from a change in the price. That is, they buy when they anticipate rising prices and sell when they anticipate declining prices. The interaction of hedgers and speculators helps to provide active, liquid and competitive markets.
Speculative participation in futures trading has become increasingly widespread with the availability of alternative methods of participation. Whereas many futures traders continue to prefer to make their own trading decisions—such as what to buy and sell and when to buy and sell—others choose to utilize the services of a professional trading advisor, or to avoid day-to-day trading responsibilities by establishing a fully managed trading account or participating in a commodity pool which is similar in concept to a mutual fund.
For those individuals who fully understand and can afford the risks which are involved, the allocation of some portion of their capital to futures trading can provide a means of achieving greater diversification and a potentially higher overall rate of return on their investments. There are also a number of ways in which futures can be used in combination with stocks, bonds and other investments.
Speculation in futures contracts, however, is clearly not appropriate for everyone. Just as it is possible to realize substantial profits in a short period of time, it is also possible to incur substantial losses in a short period of time.
The possibility of large profits or losses in relation to the initial commitment of capital stems principally from the fact that futures trading is a highly leveraged form of speculation. Only a relatively small amount of money is required to control assets having a much greater value.As we will discuss and illustrate, the leverage of futures trading can work for you when prices move in the direction you anticipate or against you when prices move in the opposite direction.
The pages which follow are intended to help provide you with the kinds of information you should obtain—and the questions you should seek answers to—before making any decision to trade futures and/or options on futures.
Topics covered include:
The regulatory structure of the futures industry
How to conduct a background check of a futures firm
How futures contracts are traded
The costs of trading
How gains and losses are realized
How options on futures are traded
How to resolve futures-related disputes
We have also included a Glossary at the back of this Guide for easy reference. In fact, we suggest that you become familiar with some of the terms included in the Glossary before continuing.
It is not the purpose of this Guide to suggest that you should—or should not—participate in futures and/or options on futures trading.That is a decision you should make only after consultation with your broker or financial advisor and in light of your own financial situation and objectives.
How the Markets are Regulated
The U.S. futures industry has experienced unprecedented growth in trading volume over the past several years, reflecting the high level of trust and confidence that customers have in the marketplace. This confidence is due in part to a strong, effective regulatory structure that safeguards market integrity and protects investors. This regulatory structure has three main components.
The Commodity Futures Trading Commission (CFTC). In 1974 Congress established the CFTC, a federal regulatory agency with jurisdiction over futures trading. The enforcement powers of the CFTC are similar to those of other major federal regulatory agencies, including the power to seek criminal prosecution by the Department of Justice where circumstances warrant such action.
National Futures Association (NFA). The same legislation authorized the creation of “registered futures associations,” giving the futures industry the opportunity to create a nationwide self-regulatory organization. NFA is the industrywide, self-regulatory organization for the U.S. futures industry. NFA’s mission is to develop rules, programs and services that safeguard market integrity, protect investors and help its Members meet their regulatory responsibilities. Firms and individuals that violate NFA rules of professional ethics and conduct or that fail to comply with financial and record-keeping requirements can, if circumstances warrant, be permanently barred from engaging in any futures-related business with the public.
U.S. futures exchanges and clearing organizations. Futures Commission Merchants (FCMs) which are members of an exchange are subject to not only CFTC and NFA regulation but also to regulation by the exchanges and clearing organizations of which they are members. Exchange and clearing corporation staffs are responsible, subject to CFTC oversight, for monitoring the business conduct and financial responsibility of their member firms . Violations of exchange rules can result in substantial fines, suspension or revocation of trading privileges, and loss of exchange or clearing corporation membership.
Although the various regulatory organizations in the futures industry have their own specific areas of authority, together they form a regulatory partnership that oversees all industry participants.
Conducting Business with a Registered Firm
Membership in NFA is mandatory, assuring that everyone conducting business with the public on the U.S. futures exchanges - more than 4,000 firms and 55,000 associates - must adhere to the same high standards of professional conduct. You can quickly verify whether a particular firm or person is currently registered with the CFTC and is an NFA Member through NFA's Background Affiliation Status Information Center (BASIC), found on NFA's Web site (www.nfa.futures.org).
BASIC contains current and historical registration information concerning all current and former CFTC registrants, including name, business address and registration history in the futures industry. BASIC also contains information concerning disciplinary actions taken by NFA, the CFTC and all the U.S. futures exchanges. If you are researching a firm, you should also conduct a background check of all the individuals listed as principals of the firm, as well as the firm's salespeople.
Sometimes the firm will have no disciplinary history, but one or more of the principals or salespeople may have been disciplined while working at other firms.
In addition, BASIC gives you details concerning NFA arbitration matters involving disputes between investors and NFA Members if the case went to hearing and an award was issued after January 1, 1990. You will also find summary data concerning the number of cases filed by investors against registered firms and individuals with the CFTC reparations program.
Introduction to Futures Trading
Futures Contracts
A futures contract is a legally binding agreement to buy or sell a commodity or financial instrument at a later date. Futures contracts are standardized according to the quality, quantity and delivery time and location for each commodity. The only variable is price.
There are two types of futures contracts, those that provide for physical delivery of a particular commodity or item and those which call for a cash settlement. The month during which delivery or settlement is to occur is specified. For example, a July futures contract is one providing for delivery or settlement in July.
It should be noted that even in the case of delivery-type futures contracts very few actually result in delivery. Not many speculators have the desire to take or make delivery of 5,000 bushels of wheat or 112,000 pounds of sugar. Rather, the vast majority of speculators in futures markets choose to realize their gains or losses by buying or selling offsetting futures contracts prior to the delivery date.
Selling a contract that was previously purchased liquidates a futures position in exactly the same way, for example, that selling 100 shares of IBM stock liquidates an earlier purchase of 100 shares of IBM stock. Similarly, a futures contract that was initially sold can be liquidated by an offsetting purchase. In either case, the resulting gain or loss is the difference between the buying price and the selling price less transaction costs (commissions and fees).
Since delivery on futures contracts is the exception rather than the rule, why do most contracts even have a delivery provision? There are two reasons. One is that it offers buyers and sellers the opportunity to take or make delivery of the physical commodity if they so choose. More importantly, however, the fact that buyers and sellers can take or make delivery helps to assure that futures prices will accurately reflect the cash market value of the commodity at the time the contract expires—i.e., that futures and cash prices will eventually converge. It is convergence that makes hedging an effective way to obtain protection against an adverse price movement in the cash market.
Cash settlement futures contracts are precisely that, contracts which are settled in cash rather than by delivery at the time the contract expires. Stock index futures contracts, for example, are settled in cash on the basis of the index number used for the final settlement. There is no provision for delivery of the shares of stock that make up the various indexes. That would be impractical. With a cash settlement contract, convergence is automatic.
Futures prices are established through competitive bidding and are immediately and continuously relayed around the world by wire and satellite. A farmer in Nebraska, a merchant in Amsterdam,an importer in Tokyo and a speculator in Ohio have simultaneous access to the latest market-derived price quotations. And, should they choose, they can establish a price level for future delivery—or for speculative purposes—simply by having their broker buy or sell the appropriate contracts.
How Prices are Quoted
Futures prices are usually quoted the same way prices are quoted in the underlying cash market.
That is, in dollars, cents, and sometimes fractions of a cent, per bushel, pound or ounce; also in dollars, cents and increments of a cent for foreign currencies; and in points and percentages of a point for financial instruments. Cash settled index contract prices are quoted in terms of an index number, usually stated to two decimal points. Be certain you understand the price quotation system for the particular futures contract you are considering.
