An efficient market for commodity futures requires a large number of market participants with diverse risk profiles. Commodities, in fact, offer immense potential. They could become an important asset class for market-savvy participants. Ownership of the underlying commodity is not essential for trading in commodity futures. Market participants simply need to deposit sufficient money with brokerage firms to cover the margin requirements. Market participants can be broadly divided into hedgers, traders, and arbitrageurs.
They are generally the commercial producers and consumers of the traded commodities. They participate in the market to manage their spot market price risk. Hedgers are in a position where they face risk associated with the price of an asset. They use derivatives to reduce or eliminate risk. For example, a farmer may use futures or options to establish the price for his crop long before he harvests it. Various factors affect the supply and demand for that crop, causing prices to rise and fall over the growing season. Commodity prices are volatile. Hence, participation in the futures market allows hedgers to hedge or protect themselves against the risk of losses from fluctuating prices. For example, a copper smelter will hedge by selling copper futures, as it faces the risk of falling copper prices.
They are traders who speculate on the direction of futures prices with the intention of making money. For traders, trading in commodity futures is an investment option. Most traders do not prefer making or accepting deliveries of the actual commodities. Instead, they liquidate their positions before the expiry date of the contract. They use derivatives to get extra leverage. Traders may buy and sell in anticipation of future price movements. But they have no desire to actually own the physical commodity.
They are traders who buy and sell to make money on price differentials across different markets. Arbitrage involves the simultaneous sale and purchase of the same commodities in different markets. Hence, arbitrageurs take advantage of a discrepancy between prices in two different markets. For example, they may see the future prices of an asset getting out of line with the cash price. In this case, they will take offsetting positions in the two markets to lock in a profit. Arbitrage keeps the prices in different markets in line with each other. Such transactions are usually risk-free.
The market functions because of the differing risk profiles of the market participants. The fluctuations in commodity prices represent both a risk and a potential for profit. Hedgers transfer this risk by foregoing the associated profit potential. Traders assume this risk in the hope of realising profits by predicting price movements. Finally, arbitrageurs make the process of price discovery more efficient.