Commodity Futures

Futures : Futures Contracts

Commodity futures are contracts that are traded on commodity exchanges. The prevailing concept of a commodity futures contract is that it affords traders of commodities a certain degree of security and confidence in transactions. This need for security largely stems out of the volatile nature of the market and ever changing commodity prices. In order to protect against potential loss through a decrease in price, and to allow for increased gain through price speculation, traders use futures contracts.

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Commodity Futures Contracts

These contracts are agreements to deliver a set amount of a commodity at a set time and for a set price established at the time of trade. For example, a trader may agree to sell an amount of coffee for a fixed price in 6 months time. If, during that time, the market price of coffee has decreased, the seller has protected himself by predetermining a price at the time of trade before the slump in the market. This can also work the other way: if the market price of coffee increases in the interim, then the buyer is presented with the ability to buy the coffee for the original lower price, and make a profit by selling it on for the later higher price. Speculating on the commodity futures can therefore be an extremely profitable or extremely damaging enterprise, depending on one’s skill in predicting market trends.

This has the effect of producing two types of buyers in the commodities market: those who merely speculate on the market to make a profit and those who are buying commodities for actual future use. As commodity trading speculators have no genuine need for the commodity other than as a route to making profit, the futures contracts are often liquidated if the price of the commodity on the market drops below an acceptable level or if the price rises sufficiently to allow for a profitable transaction. At some point before the due delivery date, both the buyer and the seller of a particular contract will often make an offsetting purchase or sale. Sometimes, in order to obtain the volume or amount of the commodity needed to satisfy a futures contract, traders will employ a type of transaction known as a spot contract, which calls for the immediate delivery of that commodity.

Commodity futures contracts are sold on margin, meaning that only a fraction of the value of a commodity one is purchasing need be put up as collateral. These margins are set by the regulators of the exchanges, who set larger margins for commodities where the price fluctuates more wildly. As a result of this, it is both possible to enjoy great gains or suffer great losses when commodity futures trading. At particular risk of loss, for example, are farmers selling futures contracts on crops that have not yet been harvested. Uncontrollable and unpredictable factors such as the weather can either be a boon or a blight to farmers and those that speculate on their commodities. Staying well informed on the various factors that affect commodity prices helps to mitigate the possibility of potential loss when investing.

Commodity futures trading involves the exchange of cash payments for contracts. These contracts are agreements to deliver certain commodities at a predetermined price, despite any fluctuations in price that may occur in the mean time. Commodity futures trading differs from standard commodity trading by the expected time of delivery: whereas standard commodity trading (or spot trading) involves an immediate delivery after the cash payment, futures trading only offers a contract for a scheduled delivery sometime in the future.

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The two types of commodity trading also differ in terms of payment. Payments in spot markets are generally paid at once and in full in return for the full amount of commodities ordered. In commodity futures trading, however, one must often only pay a percentage of the full price, the ‘margin’, until the commodities are ready for delivery. This has important implications for commodity futures brokers for it means that they can command a large amount of a certain commodity without fully paying for it. Especially if they plan on selling the contract before delivery this can increase the commodity brokers‘ margin.

Commodity Futures Market

This type of commodity trading has its roots in the 1800s agricultural market where prices for a farmers’ harvest were agreed upon months before the wheat or corn could be delivered. This protected the farmer from severe fluctuations in price depending on weather or new trade agreements and it also protected the buyer from large increases in the price of any of these agricultural commodities. Perhaps more importantly, however, futures trading also offered the buyer the opportunity to make a hefty profit. If a hundred bushels of wheat were bought at a low set price, for example, and a drought occurred, increasing the rarity and consequently the price of wheat, the buyer would still have a right to his or her hundred bushels at a price that was now extremely low. The buyer could then sell his newly acquired wheat on at twice the price paid, allowing a generous profit margin.

Thus, prices on the commodity futures market is highly influenced by the supply and demand of the chosen commodities. A commodity trader looking to make a profit through his or her investments will therefore seek to predict the trends of the market and purchase contracts according to that speculation. However, commodity futures brokers now will have little to no intention of receiving the actual commodities that they own contracts for. Instead, they will seek to sell these contracts on to others at the height of their value. Thus, some traders will hold these contracts for no longer than a day, seeking to make small quick profits from short-term trends. In this way, commodity futures trading is almost completely separated from the commodities themselves. Commodity futures trading remains the more risky form of commodity trading, where both the biggest profits and the biggest losses are made.