Futures on Commodities

Commodities are one of the most common asset classes for futures trading, and a traditional starting point for traders looking to get involved in futures for the first time.  The origins of futures can be traced back to commodities, originally developed as a tool to help merchants improve their cash flow while allowing their customers to lock in commodity quantities and prices ahead of time to help with business planning.  But how do futures work in the content of commodities, and how can this in turn be used to generate a profit for investors with no interest in handling quantities of a given raw material?

Commodity futures are widely traded on futures exchanges, quoting a price point at which traders can secure a future purchase (or sale) of the specified commodity.  For long positions, futures on commodities can be traded before the date of maturity to realise a profit (or indeed a smaller loss) on the value of the futures without having to settle the position.  It is critical to bear in mind that unlike options, futures are an obligation to buy a certain quantity at a certain period, so for that reason it is essential to cost in the impact of having to settle a heavily losing position, in addition to absorbing the loss in value of futures.

While you won’t ever have to take stock of that 1,000 bushels of wheat order you’ve placed, it’s nevertheless worthwhile calculating the risks of price movements against your position, in addition to the decay in the value of your futures that can be expected over time in order to fully appreciate the risks involved, and it is thoroughly recommended that you set guaranteed stop losses at all times to make sure you don’t lose too much on one misjudged investment.

That said, futures on commodities do have a number of key advantages over trading directly in the raw materials to which they relate.  Primarily, the lower cost barrier to entry makes it possible for even small-capital investors to generate a return from commodities.  No warehousing costs, no freight, no resale problems – it’s all handled as a cash transaction through an exchange where you don’t ever come close to seeing the product you are obliged to one day own.

Of course, with this advantage comes the natural corollary of leverage.  Because your investment is in the future right to buy commodity X, you can effectively invest in tens of thousands worth of your chosen commodity for just a fractional margin deposit.  This means you can reap the rewards of small price movements amplified across larger transaction sizes, without having to down-pay the initial capital sum.

Suppose a trader identifies a positive trend in wheat pricing, and seeks to take a long position on wheat to capitalise on what he anticipates as near future rises in wheat prices.  Fortunately, the trader makes the correct decision to invest, and wheat prices rise by 10% over the following six months.

At $10 a bushel, a $100 deposit could buy 10 bushels, excluding the cost of facilitating the trade and handling the raw commodity.  After six months, the trader could then sell his wheat at a rate of $11 a bushel (the new increased market value), to yield a gross 10% return on his investment.

But had the trader invested in wheat futures, the outlook could have been altogether different.  At a leverage of even 50:1, the same $100 capital could have afforded $5000 worth of wheat, equivalent to 500 bushels.  As a cash-settled transaction, there’s no need to take stock of any product, but it is still possible for the trader to cash in on the rise in pricing.  At the end of the six months period to which his futures contracts relate, the trader could either settle the transaction at a value of $5,500, leaving a $500 trading profit, or close out the position early to lock in a slightly lesser profit amount.  When compared with the $10 gross gains achievable through direct investment, the $500 afforded by trading futures in exactly the same conditions on the precisely same asset starts to look like an attractive option.

Of course, this is an oversimplification of how futures work in practice, but it highlights the key advantages in trading commodities via futures rather than directly, and goes some way towards identifying the core reasons why investors and fund managers choose futures as their commodity investing tool of choice.

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