Exploring Commodity Futures: What You Need to Know

Exploring Commodity Futures: What You Need to Know

Commodity Futures Contract: Definition

An agreement to purchase or sell a predefined quantity of a specific good at a given price on a given future date is known as a commodity futures contract. Commodity futures can be used to speculate on the direction of the underlying asset’s movement or to hedge or protect an investment position.

A lot of investors mix up contracts for futures and options. The holder of a futures contract is required to take action. The holder is required to purchase or sell the underlying asset at the stated price if they do not unwind the futures contract prior to its expiration.

Trading Commodity Futures: How It Works

When a commodity futures contract expires, it is typically closed out or netted. Cash settlement applies to the price differential between the opening trade and the closing trade. Usually, one uses commodity futures to speculate on an underlying asset. Typical resources consist of crude oil, corn, wheat, gold, silver, and natural gas.

Contracts for commodity futures are named by the month in which they expire; for example, a contract expiring in September is referred to as a September futures contract. There can be a considerable degree of price volatility or changes for certain commodities. Significant profits as well as significant losses are therefore possible. 

Using Commodity Futures Contracts for Speculation

Speculators can use contracts for commodity futures to place directional bets on the price of the underlying item. Investors are able to take positions in both directions, which means they can purchase or sell the commodity.

High levels of leverage are used in commodity futures to avoid requiring the investor to contribute the full contract value. Rather, a portion of the entire deal value needs to be deposited with the account broker. Depending on the broker and the commodity, different amounts of leverage may be required.

For illustration purposes, let us assume that an investor can enter a futures contract for 1,000 barrels of oil valued at $45,000 with an initial margin of $3,700, given that the price of oil is $45 per barrel. The investor will have made $15 or $15,000 if the oil price is $60 at the contract’s expiration. The net difference between the two contracts would be credited to the investor’s brokerage account upon settlement of the trades. The majority of futures contracts will settle in cash, but some will also settle when the underlying asset is delivered to a processing facility.

Given the high degree of leverage associated with futures trading, even a slight change in a commodity’s price can have a substantial impact on profits or losses relative to the initial margin. Futures trading is a complex trading strategy that is not suitable for most investors due to its high risk.

Risks Involved in Commodity Futures Speculation

Futures, in contrast to options, are contingent upon the sale or purchase of the underlying asset. Therefore, if a trade is not closed, an unskilled investor may accept the delivery of a significant quantity of undesirable goods.

For those without experience, trading commodity futures contracts can be quite dangerous. Commodity futures involve a high level of leverage, which can magnify both profits and losses. 

A margin call is when a broker requests more money to support an account that is losing money on a futures contract position. An account cannot enter into contracts until the broker authorizes it to trade on margin.

Using Commodity Futures Contracts for Hedging

Entering the futures market is also a good way to hedge against commodity price fluctuations. Companies can lock in the price of the commodities they sell or use for manufacturing by using futures.

Rather than engaging in speculation, the purpose of hedging is to shield investments against possible negative price fluctuations. A lot of businesses that hedge make use of or generate the futures contract’s underlying asset. Manufacturers, cattle breeders, farmers, and oil producers are a few examples.

Commodity futures, for instance, could be used by a plastics manufacturer to fix the price of purchasing natural gas byproducts at a later time that are required for manufacturing. Like all petroleum products, the price of natural gas is subject to large fluctuations, putting an unhedged plastics maker at risk of future cost rises.

The manufacturer would profit from the commodities hedge if a corporation locked in the price and the price increased. The additional cost of buying the commodity would be balanced by the contract’s profit. As an alternative, the business could accept delivery of the item for a predetermined, lower cost.

Benefits and Limitations of Hedging Commodity Futures 

When a corporation hedges a commodity, it may miss out on profitable price movements because the contract is fixed at a specific rate regardless of where the commodity’s price moves in the future.

In addition, the corporation may have to unwind the futures contract at a loss when selling the commodity back to the market if it over hedges and miscalculates its demands for the commodity.  The following are what to consider when it comes to hedging commodity futures.

Pros

Cons

Leveraged margin accounts just need a small portion of the original contract deposit made.

Due to the high level of leverage, losses may be amplified, margin calls may occur.

Businesses and speculators are able to trade both sides of the market.

Because the contract is fixed, hedging a commodity may cause a business to miss out on positive price movements.

Businesses can manage expenses and the price of essential commodities.

Overhedging a commodity might result in losses when the contract is unwound. 

How to Trade Commodity Futures

Trading commodity futures online is now a simple procedure. Nevertheless, you should thoroughly research any situation before taking a chance.

The following actions can assist you in getting started:

  1. Select an online commodity broker or a prop trading firm based on your preference. (Topstep is a well-known futures prop firm because of its excellent customer support, and affordable commissions.)
  2. Complete the financial paperwork needed to create a funded account.
  3. Create a trading strategy that satisfies your unique risk and return goals.
  4. Begin trading.

Risk management should be your top priority. Try to utilize modest amounts at first, and if at all possible, only execute one deal at a time. Avoid taking on too much. You may take on considerably more risk than you can manage by overtrading.