Each day, billions of dollars exchange hands as people buy and sell everything from oats to weather futures. This is because, minute by minute, the value of these commodities is changing, which affects everything from the price you pay at the pump to the price you pay for a bowl of cereal.
The quoted price for commodities is based on the supply and demand trends for that particular commodity, but all the buying and selling is done well away from any farmer's field or mine, and most transactions are executed without the participants ever seeing a bushel of soybeans or bar of gold. Read on to find out how this fast-paced and exciting market works.
TUTORIAL: Futures Trading 101
Futures Exchange Beginnings
By the middle of the nineteenth century, producers and consumers of commodities started organizing market forums to make buying and selling easier. These markets helped to establish quality standards and rules of business. In their heyday, there were more than 1,600 of these exchanges all across the U.S., mostly at major railheads or ports. (To learn more, read Futures Fundamentals.)
In the beginning, mostly agricultural goods were traded, but any market can flourish as long as there is an active pool of buyers and sellers. In Japan, for example, cocoons (for silk) are traded as an exchange-traded commodity. Over time, improvements in communications and transportation cut the need for so many local exchanges. Centralized warehouses in New York and Chicago could distribute the goods more economically; as a result, today's major U.S. commodity exchanges are in Chicago and New York.
Futures Exchanges of Today
The exchanges we see today are the result of the consolidation of the smaller exchanges. This consolidation is ongoing - for example, the Intercontinental Exchange and the New York Board of Trade merged in 2006 and the Chicago Mercantile Exchange and the Chicago Board of Trade also consolidated in 2007.
One hundred years ago, there were more than 1,000 exchanges in the U.S. Today, there are fewer than 10.
Years ago, the physical commodities were brought to the marketplace for the buyers to inspect; they would then bid on what they needed. The buyers would try to out-bid other buyers while the sellers would try to lower their prices to beat other sellers, thus creating the market.
In the present day exchanges, the physical goods are nowhere to be found and instead, traders use futures contracts. A futures contract is a legally binding contract to buy/sell a particular commodity of a specific grade at a specific price and location on a specific date. The contracts are standardized so that all market participants are on the same playing field. (To learn more about how commodities are traded, read Learn To Corral The Meat Markets and Fueling Futures In The Energy Market.)
Futures contacts are most widely used for hedging. Hedging allows producers/consumers to better estimates costs and offset risk due to market movement. Hedgers have been known to take delivery of goods. (For more on this, read A Beginner's Guide To Hedging and Commodities: The Portfolio Hedge.)
Speculators, on the other hand, try to profit from market direction and take on market risk. They usually have no need for the physical commodity, but instead try to profit on having the market go their way.
Speculators play an important role in the market price because they bring volume and liquidity. Without them, markets can dry up due to lack of buying and selling. Some exchanges, like the New York Stock Exchange, use a special type of broker who is required to trade certain stocks, ensuring liquidity. These are called specialists or market makers. It is important to note that the exchanges have no effect on the prices of the products traded. Prices are determined by the market participants, be it hedgers or speculators. If there are more buy orders than sell orders, the market will go up and vice versa. Although this process is now completed electronically, this used to be done in pits in a process called open outcry.
Open outcry may look like chaos, but it is actually a very methodical process. In the end, only the best bids and offers will reach the market. If someone is willing to pay the highest price offered, they have in effect moved all previous best bids back. According to exchange rules, no one can bid under a higher bid and no one can offer to sell higher than another offer. But this makes sense: why would you pay $9.50 for a bushel of soybeans if you can get at $9? This helps keep the market as efficient as possible, and keeps traders on their toes ensuring they can get the best deals.
Market direction is determined by the number of bids versus the number of offers. If there are more buyers than sellers, demand outweighs supply and the market goes up and vice versa. (For more on this, read Economics Basics.)
Although the traders in the pits can see each other, customers must remain anonymous. It is not uncommon for large customers to use several brokers for their larger orders to avoid tipping their hands to other market participants. Only the exchanges and the Commodity Futures Trading Commission are aware of who holds what. The pit prices are widely accepted as a reference price for the underlying commodity.
Brokers, Runners and Clerks
The pits themselves are designed to fit as many people as possible and so that each person can be seen by everyone else. They are designed in round shapes with wide steps that lead downward to the center. Any visit to an exchange will show the traders in the pits moving their arms wildly while shouting at each other. You will also see people on the edge of the pits with hand-held computers filling orders as well. More people can be found running from the phone banks to the pits and back. All this looks like chaos, but it is actually a well coordinated dance. Each individual gesture and piece of paper all work together to get the job done.
The phone clerks on the side of the exchange are taking orders from customers, time stamping those orders and giving them to runners, who take the orders to their brokers in the pits. The cryptic sounding orders brokers yell at each order in a language all their own, allowing millions of dollars of commodities to go between customers.
The buyers determine how much they are willing to pay and shout their bids to other brokers in the pit. The sellers do the same with their orders. Once the sellers and bidders find a price they can agree on, a trade has been done and they shout out "done" or "filled". Each broker is identified by the color of his or her jacket and acronyms they wear. Some brokers believe that if they wear a neon or brightly colored jacket that their orders will be seen quicker. The bigger firms make their personnel all wear the same color of jacket so that they can be easily identified.
Brokers can remember each and every trade they make in a day because they all have trading cards. These trading cards have carbon copies and are made out of a cardboard-like material so that each broker can write down his or her orders easily. An exchange employee then takes the filled orders, time stamps them and submits them to the data entry room, where key punchers input the trades into the exchange computers. With the rise of electronic trading, a lot of this information goes directly from one computer to the exchanges.
The futures trading pits can be some of the most exciting places in the financial markets as a crowd of traders flail and shout around a pit. Good information is an investor's most important tool, so while it may look like chaos in the pits, remember that there is a method to this madness.
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