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Don't Let Futures Markets Scare You: Here's How They Work

Allyson Brooks

The futures market is often an often overlooked source of wealth. Here’s how the market works and how people trade futures contracts.

How Do People Trade Futures?

Futures markets are based on futures contracts. This contract reduces expenses and possible risks for producers, bankers, and speculators. In a futures contract, an individual agrees to buy a certain amount of a commodity from a producer at a particular price and within a particular time frame. The transaction helps to secure a price for both sides and reduce the risk that the sides may incur from either a poor harvest or market forces.

The futures market is the physical or digital place where these futures contracts are set and traded. Some futures trading that occurs at physical locations like the Chicago Mercantile Exchange. Physical sites have a floor with traders who have a complex array of paper slips, shouts, and hand motions that communicate prices and trades. However, the vast majority of trading today takes place on digital platforms.

Large investors are market makers who set prices that other parties follow with their trades. These trades are often cash settlements. A cash settlement is a trade where both parties exchange rights and funds without actually exchanging the commodities. Eventually, a portion of the rice or wheat will be transferred. The farmer or producer wants to ensure that his or her commodities get sold.

What Types Of Trades Are There?

There are two types of trades in the futures market. This first is one that transfers risk. It's inherent to the market and has a considerable share of the trading volume. Those looking to produced volume trade on speculation. These traders often make numerous trades of futures contracts in a constant quest to buy low and sell high. They rarely come into contact with any physical amount of the commodity.

The futures market also has a robust derivatives market. Futures contracts are seen as an avenue to make numerous speculative bets. The certainty of futures contracts is carved apart by options. An option is a contract that gives buyers the right, but not the obligation to purchase a commodity at a particular price and at a particular period of time. Futures markets are also saddled with credit default swaps. A credit default swap is a bet either for or against the possibility of a futures contract falling through. Trading options, swaps, and other forms of derivatives thrive in the cash settlement system of futures markets.

A futures market may seem like a scary, complex place. It has massive volumes and sophisticated terminology that many casual observers may not be able to follow. However, interested investors should still give the futures market a chance. With education and prudence, an individual could find a source of value in this trillion-dollar investment field.

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