Imagine walking through a bustling global marketplace, where the prices of all commodities are being determined.
These commodities can include energy products like crude oil or natural gas, agricultural products such as corn or wheat, precious metals like gold or silver, and even livestock.
Whether we realize it or not, many of the goods we consume on a daily basis are impacted by the dynamics of commodity futures markets.
In this article, we will delve into the fundamental concepts of commodity futures, exploring what they are, how they work, and their significance in the financial world.
What are commodity futures?
Commodity futures are financial contracts obligating the buyer to purchase an asset, in this case a commodity, or the seller to sell an asset, at a predetermined future date and price. These contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange.
At the core of commodity futures is the fundamental interplay of supply and demand. These financial contracts enable entities to buy or sell a specified amount of a commodity—be it oil, gold, or wheat—at a predetermined price on a future date.
Understanding commodity futures: Key concepts
Commodity futures markets provide a platform for buyers and sellers to come together, reflecting market sentiment and expectations regarding future supply and demand conditions.
Consider this real-life example:
The January 2024 contract for US crude oil (WTI) is priced at $74.07 per barrel, expiring on 19 December 2023.
This contract, traded on the New York Mercantile Exchange (NYMEX), involves the agreement to buy or sell 1,000 barrels (contract size) of US crude oil at $74.07 per barrel on 19 December 2023, irrespective of the market price at the time of expiration.
Source: TradingView
Additional reading: Commodities: Examples, types and importance in trading
How do commodity futures work?
1. Buying a futures contract: If you are the buyer of this contract, you agree to purchase 1,000 barrels of WTI crude oil at $74.07 per barrel on the contract's expiration date. This means you are essentially locking in the price of oil today, regardless of where the market price is at the contract's expiration.
2. Selling a futures contract: Conversely, if you are the seller, you agree to deliver 1,000 barrels of WTI crude oil to the buyer at the price of $74.07 per barrel on the contract's expiration date.
3. Price movements and margin: Futures are typically traded on margin, meaning you only need to put up a fraction of the total contract value to hold a position. If the price of oil moves, margin calls can be made if the price move is against your position.
For example, if a trader wanted exposure to one standard contract (1000 barrels of oil) at $74.07 with leverage of 100 times, they would need a margin (deposit) of $740.70. However, they would get exposure to $74,070 of oil in the underlying market.
4. Settlement: On the expiration date, the contract must be settled. There are two types of settlements:
- Physical Delivery: The seller delivers the actual barrels of oil to the buyer, often at a designated location.
- Cash Settlement: No physical oil is exchanged; instead, the contract is settled in cash based on the price movement of the oil.
5. Hedging and speculation: Producers and consumers of commodities utilize futures contracts to mitigate price risk. For instance, an oil producer can sell futures contracts to protect against price declines, ensuring that they will receive a certain amount of money when selling supply in the future (a strategy known as hedging).
Conversely, manufacturers or purchasers of commodities can buy futures contracts to secure future supplies at a predetermined price, guarding against potential price increases.
Aside from serving as a hedging tool, commodity futures also appeal to investors and speculators. These individuals aim to profit from price fluctuations in commodity markets by taking positions based on their research or analysis.
But this is not for the faint-hearted; the unpredictable nature of commodity prices makes this a high-risk, high-reward game.
While investing in commodity futures can be highly lucrative, it also carries significant risks due to the volatile nature of commodity prices.
To grasp the significance of commodity futures, let's take a historical detour. Recall the 2020 global lockdowns, which drastically reduced oil demand, pushing futures into negative territory for the first time. This unprecedented event underscores the volatile nature of these markets and their deep ties to global economic forces.
Crude oil (WTI) futures daily chart showing 20 April 2020 move
Chart prepared on TradingView
6. Profit or loss: The profit or loss from the futures contract depends on the price movement of oil. For example, if the price of oil increases to $80 per barrel at expiration, the buyer profits because they can buy oil at a cheaper price ($74.07) than the market price. Conversely, the seller would incur a loss. If the price decreases, the situation reverses.
Commodity futures: risks and limitations
Before getting started in futures trading, it is important to understand the risks associated with this type of financial product.
Risks and limitations include:
| Limitation | Description |
|---|---|
| Market risk | Highly susceptible to market volatility, with price fluctuations due to external factors like weather, geopolitical events, or changes in supply and demand. |
| Liquidity risk | Some futures may have low liquidity, making it difficult to enter or exit positions without affecting the market price, especially in less popular or specialized commodities. |
| Complexity | Requires knowledge of the specific commodity market and an understanding of futures contracts and financial markets, posing a barrier for new or inexperienced traders. |
| Leverage risk | Futures are often traded on margin, allowing control of large positions with a small capital. This can amplify gains but also magnify losses, potentially leading to significant losses. |
| Regulatory risk | Subject to regulatory changes that can affect market conditions, including trading practices and reporting requirements, impacting profitability and viability of futures trading. |
| Time decay | Futures contracts have an expiration date, and as this date approaches, the value can decline regardless of the market price of the commodity. |
| Counterparty risk | There's a risk that the counterparty to the contract will default on their obligation, though this is somewhat mitigated in standardized exchanges. |
| Costs and fees | Involves various costs including brokerage fees, margin requirements, and potentially unfavorable tax treatment, which can reduce profits. |
Capitalise on volatility in commodity markets
Take a position on moving commodity prices. Never miss an opportunity.
An essential part of successful trading involves incorporating risk management at all times. By trading with stops and setting clear risk parameters, a trader can protect themselves from derailing from the strategy or plan, ensuring that the capital is protected from unfavorable market moves.
Conclusion: tapping into the pulse of the global economy
Commodity futures are more than just financial instruments; they're the pulse of our global economy, influencing everything from the cost of living to business decisions.
By understanding the basics of how these markets work, we gain insights into a world that, while complex, impacts our daily lives in countless ways.
As we navigate these markets, we harness their potential not just for financial gain, but for a deeper understanding of the economic forces that shape our world.
Additional resources:
★ Explore the wide range of soft commodities available to trade with Skilling
★ Learn the elements of markets with our new education hub
★ Read our article on commodity ETFs: a complete guide for traders
Past performance does not guarantee or predict future performance. This article is offered for general information and does not constitute investment advice. Please be informed that currently, Skilling is only offering CFDs.
