Introduction to Futures and Commodities

Posted by Pierre de la Fortune on December 20, 2015 @ 12:01 a.m.

Written by Linear Trading Staff

Walk through any supermarket or major store today and you will see the shelves lined with coffee, corn flakes, clothing, meat and even financial products. Orange juice from Spain or Florida, sugar from Central America, cereals made from oats and wheat produced in many parts of Europe and the Americas. We all consume these commodities on a daily basis but never really wonder how these items are priced, where they come from, how they get to these shelves and how they are regulated. Without the existence of the commodity futures markets around the world many of these commodities would never make it to our dining rooms or jewellery shops or hardware stores.

The words, futures, and commodities are often used together and describe the financial, physical and more exotic instruments which are traded throughout the world. Commodities are items like wheat, corn, gold and silver and Cattle and Pork Bellies and Crude Oil. It is possible to trade European rapeseed on the MATIF exchange in France to Azuki red beans on the KEX to Palm kernel oil on the KLCE. The most actively traded markets are now found in the US where the main exchanges, CBOT (Chicago Board of Trade) and CME (Chicago Mercantile Exchange) turn over millions of contracts daily.

At a simplistic level when farmers take their crop to "market", they are selling commodities. To understand how you, a speculator fits into the picture, let's look at a commodity from start to finish. Lets look at a wheat farmer who planted his crop about three months ago and in two months it will be ready to harvest. After careful analysis, the farmer calculated that it had cost about $2.50 a bushel to grow it including overheads. Anything he can sell it for over $2.50 is profit.

Right now, wheat is selling for $3.00 a bushel but the price has been going down a little every week for the last few weeks. Since it's going to be three months before the crop is ready for harvest, what can the farmer do? He is concerned that if the price continues to drop over the next three months, the price may be lower than $2.50 a bushel, which is what it cost to grow it. So what should he do? He could sell the future crop at today's price of $3.00 a bushel by calling a Broker and selling a futures contract at today's price of $3.00 a bushel to be delivered three months from now.

The risk in doing this is that if the price of wheat goes up to $3.50 a bushel during the next three months he will still only get $3.00 a bushel for it because it was pre-sold today for $3.00 a bushel. But on the other hand, if the price of wheat drops by then, he will have locked in at a price of $3.00 a bushel. This seems like a good way to go since the price of wheat has been going down, not up, in the last few weeks.

When the Broker gave a price to "sell" a contract, he acted as a middleman to find someone who would "buy" the contract. Now who would want to buy the wheat contract at $3.00 a bushel? Of course it's someone who is buying wheat and is concerned that the price of wheat will go up, not down, three months from now and they want to protect themselves in case of a price increase. So, the farmer sold a contract to lock in profits and the other person bought a contract to lock in their price and the Broker acted as a middleman and earned a commission for doing this.

However if you were a speculator you would carefully analyse the charts on wheat and yes indeed the price has been dropping and it looks like that the price is going to stop dropping and start to go back up again. The speculator thinks that in three months it's going to be $3.50 a bushel, not $3.00 a bushel that it's selling for today.

The speculator senses an opportunity to be able to buy a contract at today's price of $3.00 a bushel and hold it. If he is correct and the price goes up, he makes a profit on the commodities contract. When he buys the contract at today's price of $3.00 the person who sold the contract guarantees him that price. They must honour their end of the bargain and sell it to the speculator at $3.00 a bushel, even it the price goes up.

On the other hand, if the price goes down, the speculator loses money. How would he lose money? Because if the price of wheat three months from now is $2.50 a bushel, that means he can only sell it for $2.50 a bushel yet he agreed to buy it for $3.00 a bushel because he bought a futures contract. (When someone buys a contract that means he thinks the price is going up and makes a profit if it does. This is also called "going long". When he sells a contract he thinks the price is going down and makes a profit if it does. This is also called "going short").

The major difference in making money in stocks vs. commodities is leverage. For example: a contract in wheat is for 5,000 bushels. You don't actually buy or sell 5,000 bushels you just control 5,000 bushels. You would put up a "deposit" with a Broker for the right to do this. In the case of wheat, that "deposit" which is also called your "margin" is only $650. So, $650 controls one contract for 5,000 bushels of wheat. (Note that margins are changed quite regularly by the Exchanges generally in line with the recent volatility of that commodity. If its price has been moving in a wide range over recent months the controlling Exchange is likely to increase the margin required for you to trade that commodity. An up to date table of Contract Specifications is provided on this site).

Continuing with our example: if you had to pay all cash, as in the case of stocks, you would have to spend $3.00 X 5,000 bushels or $15,000. This is the power of leverage! You still control 5,000 bushels yet you only put up a deposit, or margin, of $650 to do so.

Let's look at how much you would make by paying cash for 5,000 bushels:

Bushels purchased 5,000 x Current Price $3 = Total Paid $15,000.

If the price of wheat went up to $3.50 per bushel you would make 50s per bushel or $2,500 profit (5,000 x 50s). Not bad, a 17% return on your investment in just 3 months.

Now let's take a look at what your return would be if you had bought a futures contract (went long) rather than paid all cash. Remember, the margin (or deposit) on a wheat contract which controls the same 5,000 bushels is just $650. If wheat did in fact go up to $3.50 a bushel you would of course still make 50s a bushel, just like you would have if you had paid full cash for 5,000 bushels or the same $2,500. The difference is that you made a 385% return in the futures vs. a 17% return for cash. That's leverage!

The Risk of Loss Is Also There - "No Risk - No Reward"

Anytime you have the potential to make a profit you also incur the potential of taking a loss. Keep in mind too that the potential loss is also leveraged. In the example above, if the price of wheat dropped 50s you would have lost $2,500. Now for the good news! You can limit your losses so that you don't have the same risk as you do reward. In other words, you can stack the odds in your favour.

There are several ways to do this, particularly with the use of stop losses and they are all described in How to Succeed Trading Futures and Commodities.

There are basically two types of traders although some people mix a little of both in their trading style. The fundamental trader, or a fundamentalist, is someone who studies the supply and demand of a given commodity. They look at things like the weather around the world, droughts or floods as an example that would affect the worlds supply. As a fundamentalist, you might buy a wheat contract because you think there is going to be a drought this summer and the price of wheat is going to go up because the supply will be down.

A technical trader bases his decisions on current and past market trends that are reflected on charts. Let's say that you are looking at a chart and you see that the price of wheat is the lowest that it has been in 20 years. Based on that, and other factors, you might "go long" a futures contract on wheat thinking that the price is going up.

One of the advantages of being a technical trader is that you don't have to become an expert on the underlining commodity. Let's say that you wanted to trade Coffee. As a technical analyst you don't have to know anything about where it comes from, weather conditions or the quality of the crop, etc. That is why nearly all of our education and information on this website and in our books is built around the art of reading charts and using technical indicators.

Who Trades Futures?

There are two basic categories of futures participants: hedgers and speculators. In general, hedgers use futures for protection against adverse future price movements in the underlying cash commodity. The rationale of hedging is based upon the demonstrated tendency of cash prices and futures values to move in tandem. Hedgers are very often businesses, or individuals, who at one point or another deal in the underlying cash commodity. Take, for instance, a major food processor who turns corn into breakfast cereal. If corn prices go up he must pay the farmer or corn dealer more. For protection against higher corn prices, the processor can "hedge" his risk exposure by buying enough corn futures contracts to cover the amount of corn he expects to buy. Since cash and futures prices do tend to move in tandem, the futures position will profit if corn prices rise enough to offset cash corn losses.

Speculators are the second major group of futures players. These participants include independent floor traders and investors. Independent floor traders, also called "locals", trade for their own accounts. Floor brokers handle trades for their personal clients or brokerage firms.

For speculators, futures have important advantages over other investments: If the trader's judgment is good he can make more money in the futures market faster because futures prices tend, on average, to change more quickly than share prices or other investments such as property. On the other hand, bad trading judgment in futures markets can cause greater losses than might be the case with other investments.

Futures are highly leveraged investments. The trader puts up a small fraction of the value of the underlying contract (usually 10%-15% and sometimes less) as margin, yet he can ride on the full value of the contract as it moves up and down. The money he puts up is not a down payment on the underlying contract, but a performance bond. The actual value of the contract is only exchanged on those rare occasions when delivery takes place. (Compare this to the stock investor who generally has to put up at least 50% of the value of his stocks.) Moreover the commodity futures investor is not charged interest on the difference between the margin and the full contract value.

In general, futures are harder to trade on inside information. After all, who can have the inside scoop on the weather or the Bank of Englands next interest rate announcement? The open outcry method of trading on some Exchanges also helps to ensure a very public, fair and efficient market.

Most commodity markets are very broad and liquid. Transactions can be completed quickly, lowering the risk of adverse market moves between the time of the decision to trade and the trade's execution. And finally, commission charges tend to be lower than with share purchases and, for UK traders, there is no such thing as Stamp Duty!

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