The Purpose of Futures

Futures are man's attempt to conquer fate. That may be putting things a bit dramatically, but the truth is that man is rarely comfortable with uncertainty, and futures allow people to eliminate, or at least reduce, life's ambiguities.

For example, when a 19th century farmer sold December corn futures in May, he knew exactly what price he would be getting for delivery of his crop, seven months ahead of time. This is the usefulness of futures.

Commodity Futures

The most common type of futures still stem from commodities. Corn, wheat, oats, soybeans, and sugar, as well as crude oil, natural gas, live cattle, and pork bellies are all examples of commodity futures. A farmer can sell a futures contract in order to lock in his price, and then buy back the same contract at a later date, either for a profit or loss, in order to avoid making delivery.

It is often impractical for a futures trader to either deliver or accept large quantities of corn or cattle, so most times; contracts are "closed out" in this fashion. For people who have an actual interest in the commodities (farmers on the sell side, large users of the commodity on the buy side), this can be seen as a form of insurance.

For people who do not have a real interest in the commodities, this is seen as speculation, or the attempt to profit by predicting price movements of the future contracts.

Financial Futures

In addition to commodities, future contracts for various financial instruments are also actively traded. There are futures for various stock indices, Federal Funds interest rates, and almost everything imaginable. The amazing thing about these futures is how accurate they tend to be.

As explained in the book, The Wisdom of Crowds, the large pool of participants in these markets create an almost supernatural, hive mentality that has an uncanny knack for getting things right. If the futures market anticipates a Federal Funds rate hike, then chances are, there is one in the works.

A Brief History of Futures

Future contracts evolved from "forward contracts." These were handshake agreements made between 19th century farmers and large buyers of their crops or livestock. For example, a farmer might have agreed in May to deliver 5,000 bushels of grain to a miller in September, at a set price.

This cut down on the stockpiling by stockyards that created price disequilibrium – the stockyards would buy grain cheap when supplies were high, and then sell it for a huge profit later in the year when their supplies began to dwindle. Farmers and large buyers decided to create forward contracts in order to eliminate these middlemen.

Unfortunately, there were problems with forward contracts. For one, buyers and sellers had a hard time finding one another – unlike in the financial markets of today. And more importantly, buyers and sellers could each renege on prior agreements without much consequence.

Future contracts, by contrast, are standardized, which makes finding buyers and sellers much easier. And they are regulated by exchanges, who enforce the contracts, if need be.

The Modern Futures Market

Today, futures are traded in the world's greatest financial marketplaces. Some of them include the Chicago Board of Trade, the Chicago Mercantile Exchange, ICE Futures, Euronext, the London Metal Exchange, the Tokyo Commodity Exchange, the New York Board of Trade, and the New York Mercantile Exchange (NYMEX).

Today's most popular commodities include crude oil and natural gas, as well as various metals, such as gold, copper, silver, and platinum.