Trading in Futures – the Origins of Speculative Investment

Posted by Deb | Guest Post | Sunday 26 February 2012 1:39 pm

by Anna Lipton

Futures are seen by more conservative investors as a wild and speculative way to invest money. Subject to wild fluctuations in potential profit or loss they are difficult to understand at first and nearly impossible to master. Those who do master them, however, enjoy superstar status. Those who fail are the rogue traders of the future. In the current maelstrom of opportunity that is the future market there is still a traceable path to history. The early futures contracts enabled greater productivity and stability boosting the economy whilst allowing some the opportunity to make huge profits on their trades.

Financial Markets Are Born To Serve A Purpose

The early railroads would not have been easily funded with debt alone. Calculating the return on a new line was tough enough in England where the distances were short and the population density high let alone when trying to calculate the possible future profit of the almost impossible to construct Canadian Western Railroad routes through the Rocky Mountains.

Train companies issued stock to speculators. Those who had cash and were looking for the extraordinary returns only possible through taking a chance on the huge potential future profits of the railroads. Thanks to the financial markets and the huge sums of money unleashed people, goods and cargo were moved swiftly across previously impossible distances.

A Tale Of The Price Of Grain

By the mid 1800’s, American farming had progressed beyond subsistence farming and basic plantations to developments that could produce significant amounts of grain. This came with significant planting, harvesting and labour costs. Add to that the cost of transporting the grain to market and farmers suddenly were developing complex business issues which could be seriously derailed by price fluctuations.

Some of their problems were solved by local commodities exchanges. These provided systems for the grading, classification and trading of commodities such as grain. There was a need for stocks in storage to be fungible – any part of an equal size would be equally suitable to use in discharging an obligation. This led to homogeneous units of grain which could be accurately priced and traded.

On top of the complex costs farmers were starting to endure they often would not have sufficient capital to develop their land. Unlike the stock investing railroad speculators we discussed earlier, the banks were keen to see that upon development on the land the resultant crops would repay the loan (much as modern credit card companies making balance transfer offers look to calculate their likelihood of repayment and future profit from interest after the initial period).

A forward contact for the delivery of that grain would significantly enhance a farmer’s chance of securing finance. On top of that, a forward contract would significantly aid the planning of a farmers business. No longer would it be mere guesswork as to what price the grain would be sold in the future – he would know exactly how much he could expend on stock, labour, finance and transport in order to return a profit at a known future price.

From Forwards To Futures

Even in these early times there developed a secondary market for forward contracts – speculators hoped to make a greater profit by taking on an obligation. There were a number of issues with these early arrangements – not least the settlement of obligations on the contract completion date. It is easy to find gamblers willing to take a bet, it’s sometimes not so easy to find a losing gambler to pay up and take delivery of the grain.

The other issue for speculation is the physical transportation or obligation to provide an amount of grain on a future date. I may feel that the market has priced forward delivery contracts on grain incorrectly but if I have no use for the tonnes of super cheap grain I obtain by making that guess it’s not ideal. Futures contracts enabled the sophisticated settling of these transactions in cash without the need for actual delivery of the underlying asset.

If grain had moved above the price specified the farmer would owe money – thus ensuring he would receive the specified price for the grain. If the grain price fell, the farmer would receive a lower price for grain but a profit on the futures contract leading again to the receipt of the specified price for the grain. This cash settlement of futures contracts offered a huge advantage over actual settlement of forward contracts when it came to speculation. By 1891 the Minneapolis Grain Exchange had put in place the kind of formal clearing and offset arrangements we see in modern futures clearing houses.

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3 Comments »

  1. Comment by Samantha — March 14, 2012 @ 4:35 pm

    There were a number of issues with these early arrangements – not least the settlement of obligations on the contract completion date. It is easy to find gamblers willing to take a bet, it’s sometimes not so easy to find a losing gambler to pay up and take delivery of the grain.
    Samantha recently posted..Health Advice

  2. Comment by John James — April 23, 2012 @ 12:48 am

    Very Good Information, but to trade futures we need a lot of experience!
    John James recently posted..How-trade-futures

  3. Comment by Chun from bad credit payday loans — June 13, 2012 @ 1:46 pm

    Excellent post. I was checking continuously this blog and I’m impressed! Extremely useful information particularly the last part :) I care for such info a lot. I was seeking this certain info for a long time. Thank you and best of luck.
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