What are Commodities Futures Contracts

The trade in commodities takes place in either spot markets or futures markets. In spot markets, the commodity trade happens immediately, in exchange for cash or other commodities. In futures markets, buyers and sellers trade a commodity based on a standardised contract. You do not have to compulsorily make or accept deliveries of physical goods here. Trade in futures contracts happens electronically and the contracts can be settled in cash.

An effective and efficient market for trading in commodity futures requires:

  • Volatility in the prices of commodities
  • Large numbers of buyers and sellers with diverse risk profiles (hedgers, speculators, and arbitrageurs)
  • The physical commodities to be fungible (i.e. it should be possible to exchange them)

What is a commodity futures contract?

A commodity futures contract is an agreement to buy or sell a specific amount of a commodity at a fixed date in the future at a predetermined price. This contract specifies further details, like the quality of the commodity and the delivery location.

An investor could take a long position (where he buys a contract) or a short position (where he sells it). If the investor expects the price of a commodity to rise, he takes a long position. If he expects the price to fall, he opts for the short position.

These contracts allow buyers of commodities to avoid the risks associated with price fluctuations of products or raw materials. For example, a manufacturer of steel instruments may buy a contract for protection against rising steel prices. The sellers of commodities enter into contracts to lock in a price for their products. For example, an oil company may take a contract to guard against a fall in oil prices in future.

Other players—like funds, arbitrageurs, and retail investors—use futures contracts to gain from price movements.

The prices of commodities change on a weekly or even daily basis. When the price of a commodity rises, the buyer of the futures contract makes money. The buyer gets the product at the lower, agreed-upon price. He can now sell it at the higher current market price. If the price falls, the seller of the futures contract makes money. The seller buys the commodity at the current lower market price. He then sells it to the futures buyer at the higher, agreed-upon price.

How are commodity futures traded?

In India, trade in commodity futures takes place on exchanges. Some well-known exchanges are the National Commodity and Derivatives Exchange (NCDEX) and the Multi Commodity Exchange of India (MCX).

When an investor buys commodity futures, he does not have to pay the full price of the contract. The investor simply has to deposit a percentage of the contract as margin with the broker. The commodities trading exchange determines the margin amount. It is typically 5–10% of the contract value.

Example :

An investor decides to buy 500 grams of silver futures for a certain price. He has to pay a certain amount as the margin. This margin amount is much lower than the actual price for 500 grams of silver.

If the price of silver increases by Rs 3,000, then Rs 3,000 is credited to his account. If the price of silver falls by Rs 500, then Rs 500 is debited from his account.

Once the investor feels that the amount gained will not change further, he may choose to sell the futures.

Features of commodity futures

  1. Organised : Commodity futures contracts always trade on an organised exchange. NCDEX and MCX are examples of exchanges in India. NYMEX, LME, and COMEX are some international exchanges.
  2. Standardised : Commodity futures contracts are highly standardised. This means the quality, quantity, and delivery date of commodities is predetermined by the exchange on which they are traded.
  3. Eliminate counter-party risk : Commodity futures exchanges use clearinghouses to guarantee fulfilment of the terms of the futures contract. This eliminates the risk of default by the other party.
  4. Facilitate margin trading : Commodity futures traders do not have to pay the entire value of a contract. They need to deposit a margin that is 5–10% of the contract value. This allows the investor to take larger positions while investing less capital..
  5. Fair practices : Government agencies regulate futures markets closely. For example, there is the Forward Markets Commission (FMC) in India and the Commodity Futures Trading Commission (CFTC) in the Unites States. The regulation ensures fair practices in these markets.
  6. Physical delivery : The actual delivery of the commodity can take place on expiry of the contract. For physical delivery, the member needs to provide the exchange with prior delivery information. He also needs to complete all delivery-related formalities as specified by the exchange.

So, who will you meet in the commodity market while trading? There are various players involved. Depending on the type of market participant they are, their trading strategy differs. This makes it imperative that you arm yourself with the knowledge of the various commodity market players like hedgers, speculators and arbitrageurs.

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