Standardisation and Liquidity

Two of the most crucial features and indeed advantages of trading futures contracts are standardisation and liquidity. Both allow futures contracts to be freely traded by speculators and end users alike, and provide by the nature of their existence a healthy, buoyant market for futures contracts across different asset types. While both standardisation and liquidity exist to make markets more fluid, it is nevertheless important for traders to have a firm understanding of the role each function plays in their trading, to better understand futures as an instrument and to get a better idea of how the futures markets work.

Standardisation is the single most important function for any tradable instrument. As the name suggests, standardisation is the process whereby all futures contracts are drawn up in a standard form, with no individual negotiation process on terms. Like a share or a bushel of wheat, a futures contract is a defined, closed package that can be easily shifted from one trader to the next without the need for due diligence, contract term negotiations etc. – by virtue of the contract being standard, only the actual subjects (i.e. the quantity, type of asset, or date of delivery) need be considered. This enables futures contracts to be traded on exchanges which would otherwise not be possible if individual traders were required to negotiate their own individual terms.

Going hand in hand with standardisation is the concept of liquidity which makes trading futures contracts possible. The notion of liquidity is perhaps best explained by reference to an example.

Cash in a bank account is almost as liquid as an asset can be. Simply stroll past any ATM anywhere in the world, insert your bank card and withdraw money. The steps between holding the asset (i.e. a positive bank balance) and holding the cash in your hand are few and simple – the asset is liquid, i.e. readily converted into cash.

Oppose that with a car. Like your bank account balance, a car is an asset that can be sold and eventually liquidated into cash. But it is less liquid than a bank balance because there are more involved steps to go through before you are able to exchange asset for cash. You’d need to advertise your car for sale, find a willing buyer, meet up, possibly allow for a test drive – all before there is any chance of getting a penny in cash.

The market for futures, as a direct result of standardisation, is liquid. There are millions of transactions constantly taking place, both on the buy and sell side, and there is a constant demand and supply of futures contracts to fill orders virtually seamlessly. What this means in practice is that it is particularly easy to transact in the futures market, and brokers are usually able to execute your orders without too much delay. Of course, this is dependent on the volume of trade, but given the standardisation and liquidity of the market, traders tend to find it relatively easy and painless to close out their futures positions.

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