Managing trading risk
A London International Financial Futures and Options Exchange case study

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Page 2: What is futures trading?

London International Financial Futures And Options 4 Image 3A future is a contract to buy or sell a standard quantity of a specific commodity or financial instrument on a fixed date in the future at a price agreed today. Futures trading can be applied to most things which stand to rise or fall in value over a period of time. In addition to commodities, futures trading takes place for a wide range of securities and currencies. Organisations with long-term needs for commodities can reduce price uncertainties by taking out a futures contract. This guarantees supply or purchase of the commodity at an agreed future date and at a price which reflects current thinking on the way prices will move.

For example, organisations which require large quantities of a certain commodity (Burger King needs vast quantities of potato chips, Nestlé requires coffee beans etc.) will seek to take advantage of the futures market by fixing their future price for buying potatoes, coffee beans and aluminium etc. In a similar way, organisations exposed to interest rate movements or price changes on the Stock Exchange will benefit from using the futures market.

Commodity futures markets allow traders, manufacturers and end-users to hedge against future price fluctuations. Trading is traditionally carried out by the method known as 'open-outcry'. Traders face each other in the trading 'ring' or 'pit' (referred to as a trading 'ping', i.e. a mixture of a ring and a pit) and shout their bids and offers. This means that everyone is completely aware of available business opportunities. Once a deal is struck, the tonnage and price are made public via computer links and through the financial and trade press. Advances in computer technology mean that it is possible to trade futures via electronic trading systems as well as open-outcry. Instant information technology connections mean that futures trading can take place via terminals on office desks and not just through local trading centres.

The futures industry

London International Financial Futures And Options 4 Diagram 1Buying and selling forward is thought to have begun in Japan with the trading of rice. In time, futures trading exchanges developed in London and Chicago (the first recognised futures contract came out of Chicago in the 19th century) with smaller exchanges opening in other cities. Initially, the Chicago exchanges concentrated on grain contracts before expanding into cattle, pig meat, soya, lumber and other agriculture-related commodities. The London exchanges originally concentrated on metals and soft commodities but have developed, over the years, to deal with a much wider range of commodities. However, in the last 25 years, there has been rapid growth in financial futures and options trading globally, covering mainly interest rate, bond and equity related products.

Since 1982, the London International Financial Futures and Option Exchange (LIFFE) has provided a market place devoted to serving the demanding and ever changing needs of the world’s financial community. LIFFE is the second largest futures and options exchange in the world and the largest in Europe. Since September 1996, it has traded agricultural and soft commodity products. The success of the Exchange has reinforced the City of London’s strategic position as a centre of international finance.

London International Financial Futures and Options Exchange | Managing trading risk