Section 1.1: The Evolution of Futures Contracts

Many people are familiar with the term "futures" in the realm of trading, but what exactly does a futures contract entail? To clarify, a futures contract is a legally binding agreement to buy or sell a particular asset at a predetermined price at a specified time in the future.

Historically, during the early days in Chicago and up until the 1970s, only physical goods—referred to as "commodities"—were traded on futures exchanges. This is why many seasoned traders still use "commodity" and "futures" interchangeably.

The shift to the term "futures" arose when intangible assets, such as T-Bonds, currencies, and stock indices, were introduced. In this context, "futures" indicates the future delivery of these assets rather than the specific items being traded.

Subsection 1.1.1: The Importance of Standardization

So, what makes futures contracts significant? The key aspect of commodity futures markets is their standardization. Exchanges establish uniform terms regarding the commodity type, quantity, quality (grade), and delivery points.

Delivery dates are also standardized within each month, creating a set period during which all contracts must be fulfilled. This means that once a contract is set, there is no need for negotiations—participants simply place their bids or offers.

By standardizing these terms, futures markets facilitate the transfer of risk from those who prefer to avoid it (hedgers) to those willing to accept it (speculators).

Section 1.2: Real-World Application

Consider the farming industry: after harvest, the supply of crops is at its peak, while it dwindles just before the next harvest. Without the ability to buy futures contracts, grain prices would fluctuate wildly, leading to instability in food prices.

Futures contracts thus serve as a stabilizing force in prices that would otherwise be erratic due to supply and demand fluctuations.