Commodity Futures: Definition, Characteristics, Benefits and More￼
Commodity trading markets, which came into existence long back, served as a location for trade between sellers and buyers for trading various commodities. These mostly included agricultural products, raw materials for manufacturing and other items.
To facilitate this trading of commodities among them, various contracts were being drawn. The introduction of such contracts slowly gave way to commodity futures trading.
So, although commodity trading or commodity futures might seem to be apparently new, they have been existing in India for a long time now. Want to try your hands in the commodity market? Then you should be aware of commodity futures and how you can trade with them. Check out the sections below for more details.
Commodity Futures Contract: What is it?
Before getting into the details of commodity futures, let’s find out about futures contracts. Futures contracts or futures are derivatives which draw their value from an underlying asset. With a futures contract, buyers and sellers can buy or sell any commodity or other asset class at a particular price and time in future.
Commodity futures contracts are agreements drawn between a seller and a buyer for purchasing or selling a specific amount of a commodity at a pre-determined price at a date in the future. As a trader, you can use the commodity futures market for the purpose of hedging an investment position. These contracts are traded on multiple products such as metals, crops, natural gas, petroleum and others.
As a buyer, you are obligated to buy the commodity on the date of expiry while the seller is also obligated to sell the commodity on the said date.
About Commodity Futures Trading
In India, you can trade commodity futures at the NCDEX or National Commodity and Derivatives Exchange as well as Multi-Commodity Exchange. There are also various notable exchanges for commodity futures trading around the world.
Commodity futures contracts are one of the most preferred modes for investing in the commodity market as it proves to be useful for various types of traders such as arbitrageurs, producers, etc.
Trading in commodity futures is standardised as the quantity, date, price, quality and other factors related to commodity futures trading are set by the exchanges themselves. Also, you need to deposit leverage for trading in these futures. Leverage is an initial deposit that you need to submit to the brokerage firm and is the percentage of the exposure.
To ensure fair play and practice, commodity futures trading is regulated and governed by SEBI. On the date of expiry, you have the option to choose whether you want to opt for physical delivery or not.
If you wish to start trading with a commodity futures contract, here’s what you need to do:
- Conduct a thorough study to educate yourself about commodity trading and commodity futures contract.
- Opt for an online brokerage platform as per your preference.
- Carry out all the KYC steps that you are asked to do.
- Chalk out a trading strategy as per your investment objectives, goals and risk appetite.
- Now, start off with trading.
If are a beginner, you can opt for professional assistance. There are also many platforms that offer professional guidance to investors.
How Do Commodity Futures Contracts Function?
In case of commodity futures contract, you, as a trader, have to lock in a price for buying or selling a specific commodity at a particular date. In case the price of the commodity goes high, you, as a buyer, will profit as you get to buy at the previously fixed price and sell off at the current market price which is higher than the price that was fixed during the agreement. But, if the current price goes below the locked price, it is the seller who will be benefitting.
Let’s take an example for a clear understanding.
Suppose a buyer purchases a contract for 500 barrels of crude oil at ₹100 per barrel. So the contract is worth ₹50,000. But if the current market price of crude oil per barrel goes up to ₹120 before the expiry date, the buyer will make a profit of ₹20 for each barrel or 500×20 which is ₹10,000. Since it would not be practical to deliver 500 barrels of crude oil physically, it has to be settled via cash.
If the buyer chooses to keep the contract for as long as the expiry date and the price of each barrel of oil goes below the strike price (₹100), he will suffer a loss as he has to buy the oil at the price fixed during the contract that is ₹100 per barrel.
Top Advantages and Disadvantages of Commodity Futures Contracts
Here are some of the major advantages of trading commodity futures:
- Firstly, commodity futures are standardised and they are regulated by exchanges.
- Commodity futures allow hedging which helps investors, traders as well as producers get rid of uncertainty and the impacts of market volatility.
- You can diversify your investment portfolio.
- To trade in futures contracts, you do not have to pay the entire value of the contract upfront. Instead, you just have to provide an initial margin.
- You will find a constant matching of buyers and sellers in the commodity futures market. You do not have to wait for long to find prospective buyers or sellers.
In addition to advantages, commodity futures come with certain drawbacks that you need to be aware of:
- Leverage in commodity futures trading can also act as a drawback. Overleveraging can lead to losses as well.
- There are chances that speculators may create artificial scarcity in commodity market by intentionally increasing or decreasing the prices.
- Futures contracts are quite volatile. Also, the commodities market can be affected by various events and price changes can be common.
Trading commodity futures can help you safeguard your portfolio as well as multiply wealth by allowing you to take part in the active commodity market. However, before you get into it, make sure that you educate yourself on the risks associated. If required, you can opt for professional assistance.
Frequently Asked Questions
Can I trade futures without a broker?
No, you will need a broker account for participating in futures trading. You can connect with an online brokerage firm, set up an account, find the contract that you wish to trade, then fill out the ticket order and easily place your trade. You will also have to pay the margin before you start trading.
Which are some of the exchanges offering commodity futures trading?
There are various exchanges across the globe involved in commodity futures trading. These include Chicago Mercantile Exchange, New York Mercantile Exchange, Multi-Commodity Exchange (MCX), National Commodity & Derivatives Exchange (NCDEX), London Metals Exchange and others.
What are the two types of settlements in futures contracts?
You can settle a contract in any of two ways: physical settlement or cash settlement. In case of cash settlement, you have to settle the contract by paying in cash. Whereas, in physical settlement, commodities are physically delivered to the buyer by the seller.
What are margins in futures trading?
Margin, also called initial margin, is the amount that you should submit for securing a position in the futures contract. The margin will be fixed by the brokerage firm that you have chosen.