What is a commodity futures contract?
A commodity futures contract is an agreement to buy or sell a predetermined quantity of commodity at a specific price on a specific date in the future. Commodity futures can be used to hedge or protect an investment position or to bet on the directional movement of the underlying asset.
Many investors confuse futures contracts with option contracts. With futures contracts, the holder has an obligation to act. Unless the holder unwinds the futures contract before maturity, they must either buy or sell the underlying asset at the price indicated.
Explanation of commodity futures
Most commodity futures are closed or cleared on their expiration date. The price difference between the original transaction and the closing transaction is settled in cash. Commodity futures are generally used to take a position in an underlying asset. Typical assets include:
- Crude oil
- Natural gas
Commodity futures are called by the name of their expiration month, which means that the contract ending in September is the September futures contract. Some products may have significant volatility or price fluctuations. As a result, there is the potential for significant gains but also significant losses.
Key points to remember
- A commodity futures contract is an agreement to buy or sell a predetermined quantity of commodity at a specific price on a specific date in the future.
- Commodity futures can be used to hedge or protect an investment position or to bet on the directional movement of the underlying asset.
- The high level of leverage used with commodity futures can amplify gains, but losses can also be amplified.
Speculate with commodity futures
Commodity futures can be used by speculators to place directional price bets on the price of the underlying asset. Positions can be taken back and forth, which means that investors can buy long (or buy) as well as short (or sell) the product.
Commodity futures use strong leverage so that the investor does not have to pay the full amount of the contract. Instead, a fraction of the total transaction amount should be placed with the broker who manages the account. The leverage required may vary depending on the commodity and the broker.
For example, suppose that an initial margin of $ 3,700 allows an investor to enter into a futures contract for 1,000 barrels of oil valued at $ 45,000, with a price of $ 45 per barrel. If the price of oil is negotiated at $ 60 at the end of the contract, the investor realizes a gain of $ 15 or a profit of $ 15,000. Transactions would be settled through the investor’s brokerage account by crediting the net difference of the two contracts. Most futures contracts will be settled in cash, but some contracts will be settled with the delivery of the underlying asset to a central processing warehouse.
Given the considerable importance of leverage with forward transactions, a slight change in the price of a commodity could lead to significant gains or losses compared to the initial margin. Speculation on futures is an advanced trading strategy and does not suit the risk tolerance of most investors.
Risks of speculation on commodities
Unlike options, futures contracts are the obligation to buy or sell the underlying asset. Therefore, failing to close an existing position could result in an inexperienced investor taking delivery of a large amount of unwanted products.
Trading in commodity futures can be very risky for the inexperienced. The high level of leverage used with commodity futures can amplify gains, but losses can also be amplified. If a futures position loses money, the broker can launch a margin call, which is a request for additional funds to consolidate the account. In addition, the broker will usually need to approve an account to trade on margin before being able to enter into contracts.
Hedging with commodity futures
As mentioned earlier, most speculative futures are settled. Another reason to enter the futures market, however, is to cover the price of the commodity. Companies use future hedges to lock in the prices of the products they sell or use in production.
The commodity futures contracts used by companies provide hedging against the risk of adverse price movements. The objective of hedging is to avoid losses due to potentially unfavorable price changes rather than speculating. Many hedging companies use or produce the underlying asset of a futures contract. Farmers, oil producers, cattle ranchers, manufacturers and many others are examples of the use of commodity hedging.
For example, a producer of plastics could use commodity futures to set a price for the purchase of natural gas by-products necessary for production at a future date. The price of natural gas – like all petroleum products – can fluctuate considerably, and as the producer needs the by-product of natural gas for production, it may increase costs in the future.
If a company locks in the price and the price goes up, the manufacturer would have a profit on the coverage of raw materials. The profit from the cover would offset the increase in the cost of purchasing the product. In addition, the company could take delivery of the product or offset the futures contract, pocketing the benefit of the net difference between the purchase price and the sale price of the futures contracts.
Risks for hedging raw materials
Hedging a product can lead a company to miss favorable price movements because the contract is blocked at a fixed rate no matter where the price of the product is negotiated afterwards. In addition, if the company misjudges its needs for raw materials and over-coverage, this could lead to having to unbolt the futures contract for a loss during resale on the market.
Leverage margin accounts require only a fraction of the total amount of the contract originally deposited.
Speculators and companies can trade on both sides of the market.
Businesses can cover the price of necessary commodities and control costs.
The high level of leverage can amplify losses and lead to margin calls and large losses.
Covering a product can lead a company to miss favorable price movements since the contract is fixed.
If a company covers more than one product, this can lead to losses if the contract is settled.
Concrete example of commodity futures
Business owners can use commodity futures to set the selling prices of their products weeks, months, or years in advance.
For example, let’s say a farmer plans to produce 1,000,000 bushels of soybeans in the next 12 months. Typically, soybean futures contracts include 5,000 bushels. The farmer’s breakeven point on a bushel of soybeans is $ 10 per bushel, which means that $ 10 is the minimum price necessary to cover the costs of producing soybeans. The farmer sees that a one-year soybean futures contract is currently priced at $ 15 a bushel.
The farmer decides to lock in the selling price of $ 15 a bushel by selling enough one-year soybean contracts to cover the crop. The farmer needs 200 futures contracts (1,000,000 bushels required / 5,000 bushels per contract = 200 contracts).
A year later, whatever the price, the farmer delivers 1,000,000 bushels and receives the blocked price of 15 x 200 contracts x 5,000 bushels, or $ 15,000,000 in total income.
However, unless soybeans were priced at $ 15 a bushel on the market by the expiration date, the farmer had either been paid more than the prevailing market price, or had missed higher prices. . If soybeans were priced at $ 13 a bushel at maturity, the farmer’s $ 15 coverage would be $ 2 per bushel above market price for a gain of $ 2,000,000. On the other hand, if soybeans traded at $ 17 a bushel at maturity, the sale price of $ 15 per contract means that the farmer would have missed an additional profit of $ 2 a bushel.