Futures Market: Standardization vs. Forward Contracting
Posted by Tom Craig in Futures Trading
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Because futures contracts are standardized, contracts are no longer between individuals, but part of the exchange. Each contract on the same commodity and delivery month is interchangeable. This is a key concept in standardization vs. forward contracting. Because each contract is the same, one can establish a futures position and exit out of it without ever accepting delivery, with the only variable being price.
For example, assume you buy one contract of Corn for March delivery, where one contract of Corn is equal to 5,000 bushels. If at a later time, before March, you (the holder of the futures contract) wish to exit your position, you can simply sell the same Futures contract, which will result in either a profit or loss depending upon the pricing at entry and exit. At no point in this process do you have to actually handle the physical grain, as the futures contract represents an obligation to make or accept delivery of a specific amount and quality of a commodity at a specific point in the future. Until the futures contract enters into a delivery period, the contract can simply be offset by entering an opposite position in the futures market.
Standardization of contract terms and the ability to offset contracts led to the rapid increase in the use of futures contracts by commercial firms and speculators. Commercial firms were quick to realize that futures markets offered them protection against price volatility without the need to make or take delivery of the physical commodity, because they could be offset. Speculators found that standardization added trading appeal to the contracts because contracts could be bought and sold, or sold and bought, at a profit if they were correct in their forecasts of price movement, without ever having to deal with the physical commodity.
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