Commodities Futures Trading Requires Standardized Contracts

Organized trading of commodities in the USA for agricultural products during the 1840s. It involved spot trades that required immediate physical delivery.Commodities futures trading
soon emerged a decade or two later when a standardized forward contract was developed in 1864 in Chicago.

In contrast to forward and spot markets, trading in futures markets is based on highly uniform contracts that specify physical delivery in the more distant future, sometimes several years from the present. Importantly, futures traders do not generally plan on making physical delivery since they will place an offsetting trade, hopefully at a profit, before the contractual delivery date.

The specified delivery date is delayed into the future, sometimes years ahead. Critically however, futures traders do not anticipate ever making delivery since they will trade-out of their original position by an opposite trade before the specified date of delivery.

Since the originating trade date and the delivery date are considerably apart in time, the value of a futures contract fluctuates in line with changing market supply and demand conditions for the commodity. The associated price fluctuations provide trading opportunities.

Commodities are undifferentiated products. They are usually unprocessed raw materials. Their homogeneity makes them attractive candidates for futures trading which depend greatly on standardization.

Commodity markets are global in nature. Both spot and derivative price changes are rapidly recognized on all exchanges.

Closing decades of the last century witnessed rapid growth in the trading of commodities futures, much faster than spot transactions. Industry traders suggest this reflects various innovations that improved the ability of futures, and derivatives generally, to effectively manage risk. On the other hand critics highlight that the growth of futures trading bears little connection to the growth of underlying physical production and hence largely reflects speculation that adds little value to the community.

In futures commodities trading, the buyer and seller may be seeking to transfer (hedge) risk or to assume risk (speculate). Generally, one party is a hedger and the other a speculator. However it is possible that both buyer and seller may be attempting to hedge or speculate, with each having different views of the future and these different perspectives forming the basis for the trade.

It is not possible for an outside observer to assess whether a futures buyer or seller is seeking to hedge or speculate. Ignoring the fact that most trades are placed by a broker acting as agent rather than principal, the trading objective depends critically on the opening exposure of a principal and that data is a private matter.

Commodity markets are global. Price movements on one exchange very quickly impact other exchanges globally.

Both a forward contract and a futures contract specify delivery beyond the immediate future. However, a forward contract is a non-standard agreement customized to the individual requirement of its two parties. There is little effort made to design that contract in a way that will encourage the secondary trading of that contract beyond its two originating parties. By contrast, a futures contract may be thought of as a standardized, exchange traded forward contract designed specifically to promote its secondary trading.

A wheat farmer agreeing to sell his estimated crop this season to, say, his local agricultural agent is an example of a forward contract. That same farmer calling his commodities broker and placing a sell order for a number of wheat futures contracts covering the same estimated volume is an example of commodities futures trading.