Suppose you and I live in a rural Illinois town. I raise cattle. You grow corn 15 miles from my ranch. In each fall, when you have finished raising your harvest, you pack all your produce and send it to me; I buy it to feed my steers. To reach a fair settlement, we agree that I will pay you the cash price for corn that is traded at the Chicago Board of Trade on the day you leave the merchandise for me.
The corn is important for both
This is their main plantation; this is the main cost to feed my cattle. I expect low corn prices. Throughout the summer you are praying that something positive – like an unexpected purchase by the Russians, for example – will raise corn prices.
One spring day you come to visit me and suggest the following: “We are going to agree on the price of corn now for next fall,” he says. “We are going to agree on a price that allows us both to make a reasonable profit. So in this way, neither of us has to worry about the price of corn in September. We will be able to plan better. We will be able to continue with our businesses, with the certainty of what we will pay and receive for the corn. “
I agreed, and we agreed on a price of $ 2.50 per “bushel” (old agricultural measure only used in the US; 36.74 bushels = 1 metric TON). This agreement is called an advance contract – a “contract” because it is an agreement between a buyer (me) and a seller (you); “advance” because we are going to carry out the real transaction later, or in the future.
It’s a good idea, but it always has its flaws
Suppose the Russians do announce a surprise purchase of corn, and prices rise to $ 3.00. You would now be looking for a way to put the contract aside. In the same way, I would not be very willing to bear our agreement if a bountiful harvest causes prices to drop to $ 2.00 per bushel of corn.
Now, there are other reasons why our advance contract might not come to fruition. A hail storm could completely destroy your corn crop. I could sell my ranch with all livestock included, and the new owner cannot be held responsible for the deal. Either one could file for bankruptcy.
The futures market was invented to solve these problems with contracts in advance, while retaining all other benefits. A futures contract is the same as an advance contract with a few added conditions.
There are some basic concepts that you should understand before investing in the futures market. The first thing is the futures contract itself. In the introduction we told you that a futures contract is simply an advance contract with a few more conditions. One of these conditions is standardization.
An advance contract can be issued for any commodity (consumer item or product). It can also be issued for any amount or delivery date. If you want to buy 1400 bushels of “silver queen” corn to be delivered to your doorstep next June 2, you can do this with an advance contract. You cannot do this in the futures market.
The futures market is for a specific grade of product, quantity, and month of delivery. For example, the Chicago Board of Trade (CBOT) futures contract for corn is traded for 5,000 bushels (quantity) of No.2 yellow corn (grade). The delivery months are March, May, July, September and December. There are no other delivery months, nor other quantities available. All futures contracts are standardized in this way. This was done to make the futures contracts specific and interchangeable. Degree, quantity, and month of delivery are specified by the broker when the contract is designated. Only the price is left to be determined.
Another difference is where the business can be done. An advance contract can be issued anywhere. Futures contracts are bought or sold only on the exchanges by members of the exchange.