Commodity futures are agreements that enable investors to profit from future changes in the market price of certain raw materials. The futures contract sets up a trade that will be completed at an agreed price and date. The difference between the agreed price and the market price at the end of the contract will determine whether you make a profit.
A commodity is simply a physical good that can be bought and sold. It is usually a raw or unprocessed material that is relatively uniform. One barrel of crude oil is the same as the next, so they can be sold for the same price on the market. The commodities that are of interest to investors include gold, oil and corn. These represent the three main classes of commodities: metals, energy and farming. The prices of these commodities can go up and down over time because of changes in supply and demand. Investors can take advantage of these changes in order to make a profit. However, it is not necessary to actually buy these goods in order to make money. You can trade in futures instead.
Futures are agreements to buy something at a set price on a specific date in the future. It is different from an option, which only gives you the chance to buy or sell if you choose. A futures contract is an obligation to make the trade. You can trade in futures on various markets, including stocks and currencies as well as commodities.
Commodities are traded at exchanges that focus on specific goods that are always in high demand. The commodities can be bought and sold at the exchange just like shares, but investors usually trade in commodity futures. These are futures contracts for commodities.
Commodities futures are traded on exchanges that may only deal with certain types of commodities. For example, the London Metal Exchange only deals in gold and other metals. Other exchanges trade in a broader range of commodities. The exchanges set standards for the commodities that are traded to ensure that all units of a particular good are of the same quality.
Commodities markets exist in order to protect the producers who create these goods and the consumers who will end up using them. Without the exchanges, the fluctuations in commodity prices could drive farmers and other producers out of business. Consumers would also suffer because of sudden price rises and issues with supply. The market enables prices to be settled before the goods are sold. It also gives farmers, oil companies and other producers a means of protecting themselves against unforeseen problems such as a bad harvest or oil spill. However, most of the trades made on commodity markets don’t actually lead to the exchange of physical goods. Investors use these markets to make money rather than to actually buy barrels of oil.
Commodity futures can be bought through brokers in a similar way to stocks. The broker will make the trade at the exchange on your behalf. You will first need to choose the type of commodity you want to trade and to consider how its price is likely to change. You should then compare the futures contracts offered by your broker to find one that will enable you to make a profit if your prediction is correct.
A futures contract specifies:
The contract itself has no inherent value and you do not own the commodity itself. Whether you will make a profit or a loss depends on how the market moves between the time when you invest and the date on the contract. The contract is finite and it will expire on this date. You may be able to sell the contract to another investor before this date, but you cannot continue holding your investment after it.
For example, if you think that the price of gold is likely to rise, you might want to buy a futures contract that expires in six months. If you can find a futures contract selling now for $1500 an ounce then you will make a profit if the price is higher when the contract ends. The contract enables a certain amount of gold to be bought at $1500, which will then be sold at the current market price. If gold is selling at $1700 at the end of the six months you will make a profit of $200 for every ounce covered by your contract. You can also choose to go short on a futures contract so that you will make a profit if the price falls. However, if your prediction is wrong you will lose money.
Commodities futures are usually leveraged, which means that you will only need to deposit a portion of the value represented by the contract into your trading account. The amount that is required will be a certain percentage of the value. You will need to keep a certain margin in your account even if the value of your contract falls, otherwise your position will be closed automatically.
Leveraging can increase the profits that you make when your investment goes well, but it will magnify your losses too. You are also at risk of owing your broker money if the losses exceed your initial deposit. However, you can minimise the potential losses by setting up a stop order that will automatically close your position if they exceed a certain amount.
Commodities can also be traded in spot markets, buying and selling immediately at current market prices. However, this kind of trading is mainly for businesses that are actually producing or using the goods. The futures market depends on the presence of these buyers and sellers, as they are the ones who ensure that trades are always possible and give the commodities market its main purpose.
Commodities are traded 24 hours a day, seven days a week. Trading costs also tend to be low. However, trading in futures can be very unpredictable. Commodities markets can be very volatile and there can be big changes during the time period your futures contract covers.
If you are planning to trade in commodity futures, you will need to predict what the price will be on the date given in your contract. Trading in futures is always risky because you are committing to a set price on a date that could be a month or a year away. Many things could change between the time when you invest and the day when the contract expires. You won’t be able to react to these changes in the same way that you could to movements in the stock market. If your shares go down, you can decide to sell them. If the market price for the commodity you’re trading in falls, you’ll only be able to wait and see if it goes up again by the date in your futures contract.
Commodity prices are usually determined by changes in supply and demand, but the factors that affect these are different for each type of commodity:
Soft commodities such as corn and other agricultural products tend to be more volatile than hard commodities such as oil, gold and other mining products. Investors tend to focus on the more predictable, slower moving hard commodities, but these can still be unpredictable. For example, oil prices can react to political decisions or instability, which can be very unexpected.
Commodity futures can be used for several kinds of investment strategy.
