Futures Trading 
An Introduction To The World Of Future Trading
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Futures Trading  - Price Discovery

I hope by now that you are starting to realise that trading in the futures market is unlike any other. Indeed in many ways it is a true reflection of the real world, since many of the contracts traded are for real things which we use every day such as oil, coffee, meat and basic raw materials. Since the futures market is both highly active and a global market place, it provides economists around the world with both a market sentiment indicator, as well as a view on the balance of supply and demand in basic commodities and foodstuffs.

Futures Trading - Determining The Price

If we start with a definition of price discovery it is simply this:

Price discovery is a method of determining the price for a specific commodity or security through the basic supply and demand factors related to the market.

Now futures prices increase and decrease largely because of the range of factors that influence buyers and sellers judgments about what a particular commodity will be worth at a given time in the future. These factors change almost continuously and can be anything from natural disasters to political instability in a particular region,  to supply issues or seasonal variations. All of these and many others will influence traders and speculators in their overall view of a particular market, and hence whether the future contract increases or decrease in price, at that particular time.

Competitive price discovery is a major economic function now used by many economists around the world, and in a strange way is one of the few places where economics and trading combine to provide a balanced view of world markets. The only certainty in the futures market is that prices will change - by how much and when is a function of market conditions as communicated by the market from the trading floor. In other words in a free market, prices are determined by what the seller can get from the buyer or what the market will bear.

Futures Trading - Daily Price Limits

Now, ironically, having said that this is a free market and the prices are dictated by the economics of supply and demand, the exchanges do set daily price limits for trading in futures contracts. These limits are actually stated in terms of the previous day's closing price, plus or minus  a certain number of cents or dollars per trading unit. Once a price has increased by it's daily limit there is no further trading at any higher prices until the following day, and the same applies if a price falls below the limit set. For some contracts daily price limits are eliminated during the month in which the contract expires.

Daily price limits set by the exchanges are subject to change, and can be increased once the market price has increased or decreased by the existing limit for a given number of successive days. Because of daily price limits, there may be occasions when it is not possible to liquidate an existing futures position so please bear this is mind when trading futures.  Just to give you a real life example, China has recently introduced gold futures on the Shanghai Futures Exchange according to the Financial Times in London - part of the statement included the following:

"The Shanghai exchange, one of the country’s three commodities futures exchanges, has already set the size of its gold futures contracts at 1,000 grams per lot and established a 5 per cent limit on daily price movements as well as a minimum margin requirement of 7 per cent of the gold contract value."

OK- now having looked at price discovery and market price limits, let's look at one of the other factors that help to keep futures trading prices in check and balance - its called arbitrage.

 

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