In this article, we will cover
» Commodity futures trading
» What are commodity futures?
» How does commodity future contracts work?
» Advantages of commodity futures
Commodity futures trading
Commodity trading is trading in the primary economic sector comprising basic raw materials required at the top of the production chain, and agricultural commodities needed for daily sustenance and livelihood, as compared to trading in companies involved in the manufacturing or processing of finished goods.
Commodity market was earlier conceived to provide a centralised location for the buyers and sellers, to come together, and transact as per their requirements.
The buyers and sellers included producers engaged in the cultivation of the crops or extraction of natural resources and consumers of such commodities for consumption or engaged in the further processing of the commodities.
They were often scattered across the length, and the breadth of the region and the market provided them with a focal point to find a prospective buyer or seller, where all the hustle and bustle of the trade activity took place. It all started in 1848, compelled by the need for an assured supply of seasonal crops.
Hence, contracts were drawn stating the price and the quantity of the crops to be delivered at the time of the harvest. Similarly, contracts were drawn for metals, energy, and agricultural commodities that were not yet produced or manufactured, but an arrangement was made where the prices, quantity and the date of the delivery i.e. when the crops would be harvested and available for delivery was decided. This led to the emergence of commodity futures.
Although there are multiple ways to trade in commodities, commodity futures are the most dominant way of trading in commodities for their inherent utility for all types of traders, be it producers, speculators, arbitrageurs or industrialists.
What are commodity futures?
A futures contract is a binding legal obligation to buy or sell the underlying commodity in stipulated quantities at a predetermined price on the expiry date in the future. The buyer is obliged to purchase or receive the delivery of the underlying commodity on the expiry date, while the seller is obliged to sell or make the delivery of the underlying commodity on the expiry date, considering the contract is not closed and cash-settled before the specified date.
In easy terms, Let's say Ram agrees to buy 100 kgs of silver from Shyam at Rs.45000/kg on 30th Oct from today and they sign a contract. Let's assume the price of silver shoots up to Rs.50,000/kg, and Ram further sells his Silver (rights to buy or contract) to Ramesh at Rs.50,000/kg. In this case, Ram will earn the difference of Rs.5000 and settle the contract.
This whole agreement of buying silver at a fixed price on a selected date is a future contract. Now let us understand how it exactly works.
How does commodity future contracts work?
The way future contracts work is that you lock in a price at which you are willing to buy or sell the underlying commodity at a specified date in the future. When the prices go above the lock-in price, the buyer registers a profit, and the seller suffers a corresponding loss. Theoretically, it means that the buyer can buy the necessary commodity in the agreed quantities at the set price, and sell in the open market at the current market price, which is higher than the locked-in price. Conversely, if the prices remain below the lock-in price, the seller profits at the expense of the buyer.
E.g, A buyer buys 100 contracts comprising 100 barrels per contract at Rs 120 per barrel ending on 31st Jan. Hence, the buyer bought contracts worth Rs 12,00,000. However, you are not required to pay such a massive amount to gain exposure to the contract, as we'll understand later.
In case the current market price shoots to Rs 140 in the interim, and the buyer chooses to close the contract, he will book a considerable profit amounting to the difference between the futures price, i.e. Rs 120, mutually agreed at the initiation of the contract and the current market price, i.e. Rs 140, i.e. (140-120=Rs 20), Rs 20 multiplied by the number of contracts, further multiplied by the number of barrels per contract, i.e. 20*100*100, which finally comes to Rs 2,00,000. However, in such a case, settlement happens on a cash basis where Rs 2,00,000 is debited from the seller's account and credited to the buyer's account.
However, if the buyer holds the contract till the expiry date, and the spot price on the expiry date is Rs 110, the buyer is obliged to receive the delivery of the underlying commodity, i.e. 10,000 barrels of oil at Rs 120, regardless of a lower spot price, where he can buy the same barrels of oil at a lesser
price of Rs 110.
However, it would not be feasible to deliver 10,000 barrels of oil; hence in the modern-day, the contract will be liquidated and settled in cash, where the buyer experiences a loss of 1,00,000, while the seller enjoys the corresponding gains.
Also, nowadays, investors trade in the futures market to hedge or profit from price fluctuation of the underlying commodity; they are rarely interested in the physical delivery of goods.In the above example, it would not be economical or even convenient to shell out the massive amount of Rs 12,00,000 to buy the oil futures contract. However, every futures contract has a requirement of a relatively little amount to be placed to accommodate the daily mark to market gains and losses of the futures contract known as initial margin.
[Suggested Reading: How to Invest in Commodities]
Initial Margin is the amount calculated as a percentage of the total value of the contract required to be placed with the broker before taking a position in the futures contract. Let us say the above futures contract may require an initial margin of 5% of the total value of the contract, i.e. 5% of Rs 12,00,000. Hence, with only Rs 60,000 in the account, you are buying a contract worth Rs 12,00,000. The profit and loss will be calculated based on the total value of the contract, i.e. Rs 12,00,000.
Also, if the losses deduce the initial margin below a prescribed limit known as the maintenance margin, calls will be made to deposit additional funds, to bring the level back to the initial margin. Maintenance margin is the minimum amount required to be maintained at all times to prevent the broker from liquidating your futures position in case of acute losses.
Let's say continuing with the above example where the initial margin is Rs 60,000; the maintenance margin is Rs 40,000. Let's say if the price of oil falls by Rs 30,000, which reduces your initial margin to Rs 30,000. Here the initial margin falls below the prescribed limit of maintenance margin; now calls will be made to deposit Rs 20,000 to bring it to the level of the initial margin, the non-compliance of which will force the broker to liquidate your position and close the contract.
Advantages of commodity futures
Commodity futures have a lot of advantages, which makes it an attractive investment opportunity for all participants in an economy such as traders, speculators, industrialists, farmers, etc. Let us look at some of the advantages:
Commodity futures provide the opportunity to amplify returns by gaining exposure to a large amount by placing only a fraction of the total value as initial margin. Hence, any small movement in the prices can lead to substantial gains as the gains are calculated based on the total value of the contract, irrespective of the relatively little amount as initial margin placed.
Hence, continuing with the above example, if the price of the oil rises by Rs 10 to Rs 130, then the gains on one barrel of oil is jacked up substantially by multiplying with the total barrels of oil based on the futures contracts bought, i.e. 10,000. Hence, you enjoy considerable gains of Rs 1,00,000, based on a relatively little price movement.
The prices of the commodities are highly volatile and unpredictable as it is influenced by a lot of tertiary factors such as geopolitical conflicts, adverse weather, etc. Commodity futures allow us to lock-in a price to hedge against the risk of adverse price fluctuations. Usually, people engaged in the business of imports and exports are wary about the future price fluctuations that may lead to shelling out more from their pockets to the extent that they suffer considerable losses. Hence commodity futures allow them to sell the commodities at a specific price in the future, which guarantees them a reasonable rate of return and also ensures the supply to the buyer. With the futures, the exporter also ensures that there is a buyer when the commodity is ready for export.
The airline industry is an example of a sector that must secure vast amounts of fuel at guaranteed and stable prices. By trading in futures contracts, they secure the prices of the fuel, to hedge against the risk of enormous volatility in the prices of crude oil that may disrupt their plans and dampen their earnings.
Commodity futures help you to buy or sell commodities at a price set months before the commodities are ready for sale, thus ironing out any price changes in the interim.
There is total transparency as all the trades are transacted on an open electronic trading platform. This avoids the rigging of prices or any form of manipulation. Also, the buyer and seller remain anonymous, which avoids any arm-twisting and manipulation in prices due to intervention by the buyers or sellers. Such a transparent system enables price discovery solely based on the market fundamentals comprising supply and demand of the commodities.
Suppose you are a businessman or an industrialist engaged in the production and manufacturing of finished goods for utility and consumption. Any changes in the prices of the raw materials procured will hike up the price of the finished goods, which will compel you to transfer the hike to the consumer, making your products expensive and unattractive for the market. This may create a dent in your market share, and drop you many levels in the competition.
On the other hand, if you fail to pass on the costs, it will deplete your margins, and your profitability will take a toll, making your company a lot unattractive for the shareholders due to
low earnings per share.
Hence, with commodity futures, you have complete control over the cost of the raw materials as you can buy a futures contract to lock-in a price, and accordingly plan your production schedules strategically, and also take certain management decisions to maintain the competitive price of the product and preserve the financial health of the company.
With commodity futures, there is a constant and instant matching of buyers and sellers. Any surplus in the physical market will result in a never-ending wait for a prospective buyer. However, the commodity futures contract is a binding obligation which ensures that the buyer must buy the commodity at the mutually agreed price at a specified date in the future, thus enabling assured demand for the commodities.
Commodity prices have a negative or low correlation to equities. Usually, during inflation and recession, commodity prices tend to rise. Hence, when the economy is declining, and stock markets are crashing, commodity prices may rise due to the increasing prices of essential commodities required for subsistence in an inflationary environment or during a recession when investors move to commodities like gold generally regarded as a safe asset in such trying times. Hence, commodity futures can provide adequate diversification to a portfolio with equities and even bonds.
Hence, commodity futures are an integral part of the economy. The effective management and trading of commodity futures can provide not only protection against a diverse range of risks but also enable wealth generation.
While commodity futures are primarily used for hedging, speculators have also used futures and options contracts to create abundant wealth in commodity markets.
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