Futures trading is the process of buying or selling some predetermined asset at a mutually-agreed upon price. This agreement is called a futures contract and it is paid out on a specified delivery date, which is usually in the future. This process occurs at a futures exchange, where the buyer is also called the “long” party and the seller is the “short” party. These designations reflect how the contract is seen in the eyes of each member of the agreement. The person buying the asset hopes that the value of those assets will increase in the future, while the seller hopes that the price will decrease before the sale.
A futures contract is highly standardized. That means that it specifies a number of things, including what the asset up for sale is. The asset might range from an interest rate at a bank, to foreign currency, to a quantity of oil. The contract should clearly indicate the number of units that will be sold. When the contract involves physical commodities, it must also indicate clearly the quality of those contents, otherwise known as the grade. For instance, when crude oil is being traded, the oil must adhere to certain standards which are outlined in the agreement between both the long and short parties.
The contract should also specify how the settlement will be paid out in the future, whether the payment will be made in cash and what currency will be used to make the payment. Finally, the contract must state when the delivery will take place and when final trading will occur. Another detail often included in the futures contract is something known as a commodity tick, which determines by what percentage the market may fluctuate before the delivery date.
There is usually a mediating party in every futures exchange. This process began in the early 1970s when the Chicago Mercantile Exchange (CME) introduced future contracts for financial transactions. It became highly successful and helped to increase the volume of trading and open international access to markets. Following this success, new markets opened up around the world, with the London International Financial Futures Exchange, the Terminborse, and the Tokyo Commodity Exchange becoming just three of over 90 institutions that specialize in futures exchanges.
This innovation stems back to the trading of commodities in Japan in the 18th century. At that time, goods such as silk and rice were being traded in markets. In the west, Holland traded tulip bulbs and the United States began trading later, in the middle of the 19th century. In the U.S., trading took place between farmers who sold their grain produce to buyers either immediately or to be delivered at a later date. These early contracts were the basis for futures trading today.
The term settlement refers to the consummation of the contract, as it is specified. This can be done as either a physical delivery or a cash settlement. The physical delivery process is when the asset denoted in the contract is passed from the seller to the buyer of the contract. This practice is common with most bonds and commodities that are traded; however, it does not occur with all contracts. In fact, contracts are often canceled by other contracts known as covering positions, for either the long or short party.
The second type of settlement is simply a cash payment. These funds are transferred according to the agreed-upon currency and rate. This is usually based on a stock market index or an interest rate index over the course of the transaction. The contract is settled when one party receives the payment for a loss at the time of the contract’s expiration. In the case of cash settlements, most often the asset in question cannot actually be delivered. It is most often not a physical object.