Commodity Futures Contract
What Is a Commodity Futures Contract?
A commodity futures contract is an agreement to buy or sell a predetermined amount of a commodity at a specific price on a specific date later on. Commodity futures can be utilized to hedge or safeguard an investment position or to wager on the directional move of the underlying asset.
Numerous investors confound futures contracts with options contracts. With futures contracts, the holder has an obligation to act. Except if the holder unwinds the futures contract before expiration, they must either buy or sell the underlying asset at the stated price.
Commodity futures can be appeared differently in relation to the spot commodities market.
How a Commodity Futures Contract Works
Most commodity futures contracts are closed out or netted at their expiration date. The price difference between the original trade and the closing trade is cash-settled. Commodity futures are typically used to take a position in an underlying asset. Common assets include:
- Crude oil
- Natural gas
Commodity futures contracts are called by the name of their expiration month, meaning a contract ending in September is a September futures contract. A few commodities can have a lot of price volatility or price changes. Thus, there's the potential for large gains yet large losses also.
Commodity futures and commodity forward contracts are practically comparable. The major difference is that futures are traded on regulated exchanges and have normalized contract terms. Forwards instead trade over-the-counter (OTC) and have adaptable terms.
Speculating with Commodity Futures Contracts
Commodities futures contracts can be utilized by speculators to make directional price wagers on the underlying asset's price. Positions can be steered in either course, meaning investors can go long (or buy), as well as go short (or sell) the commodity.
Commodity futures utilize a high degree of leverage with the goal that the investor doesn't have to put up the total amount of the contract. Instead, a fraction of the total trade amount must be put with the broker handling the account. The amount of leverage required can shift, given the commodity and the broker.
For instance, suppose a initial margin amount of $3,700 allows an investor to go into a futures contract for 1,000 barrels of oil valued at $45,000 — with oil priced at $45 per barrel. On the off chance that the price of oil is trading at $60 at the contract's expiry, the investor has a $15 gain or a $15,000 profit. The trades would settle through the investor's brokerage account crediting the net difference of the two contracts. Most futures contracts will be cash-settled, however a few contracts will settle with the delivery of the underlying asset to a centralized processing warehouse.
Considering the huge amount of leverage with futures trading, a small move in the price of a commodity could bring about large gains or losses compared to the initial margin. Speculating on futures is an advanced trading strategy and not good for the risk tolerance of most investors.
Risks of Commodity Speculating
Not at all like options, futures are the obligation of the purchase or sale of the underlying asset. Thus, inability to close an existing position could bring about an inexperienced investor taking delivery of a large number of undesirable commodities.
Trading in commodity futures contracts can be extremely risky for the inexperienced. The high degree of leverage utilized with commodity futures can enhance gains, as well as losses. On the off chance that a futures contract position is losing money, the broker can initiate a margin call, which is a demand for extra funds to support the account. The broker will generally need to support an account to trade on margins before it can go into contracts.
Hedging with Commodity Futures Contracts
Another motivation to enter the futures market is to hedge the price of a commodity. Businesses use futures to lock in prices of the commodities they sell or use in production.
The goal of hedging is to prevent losses from possibly unfavorable price changes rather than to estimate. Many companies that hedge use or produce the underlying asset of a futures contract. Models include farmers, oil producers, domesticated animals raisers, and manufacturers.
For instance, a plastics producer could utilize commodity futures to lock in a price for buying natural gas results required for production at a date later on. The price of natural gas — like all petroleum products — can change extensively, leaving an unhedged plastics producer at risk of cost increases later on.
On the off chance that a company locks in the price and the price increases, the manufacturer would have a profit on the commodity hedge. The profit from the contract would offset the increased cost of purchasing the product. On the other hand, the company could take delivery of the product at a less expensive fixed price.
Risks of Commodity Hedging
Hedging a commodity can lead to a company missing out on great price moves since the contract is locked in at a fixed rate paying little mind to where the commodity's price trades a short time later.
Likewise, in the event that the company misjudges its requirements for the commodity and over-hedges, it could lead to having to unwind the futures contract for a loss while selling it back to the market.
Business owners can utilize commodity futures contracts to fix the selling prices of their products weeks, months, or years in advance.
For instance, suppose a rancher hopes to deliver a million bushels of soybeans in the next 12 months. Typically, soybean futures contracts include the quantity of 5,000 bushels. The rancher's break-even point on a bushel of soybeans is $10 per bushel, meaning $10 is the minimum price expected to cover the costs of producing the soybeans.
The rancher sees that a one-year futures contract for soybeans is at present priced at $15 per bushel. The rancher chooses to lock in the $15 selling price per bushel by selling sufficient one-year soybean contracts to cover the harvest. The rancher needs 200 futures contracts (a million bushels required/5,000 bushels for every contract = 200 contracts).
After one year, paying little heed to price, the rancher conveys the a million bushels and gets the locked-in price of $15 x 200 contracts x 5000 bushels, or $15,000,000 in total income.
Except if soybeans were priced at $15 per bushel in the market on the expiration date, the rancher had either gotten compensated more than the prevailing market price or passed up higher prices. On the off chance that soybeans were priced at $13 per bushel at expiry, the rancher's $15 hedge would be $2 per bushel higher than the market price for a gain of $2,000,000. Then again, on the off chance that soybeans were trading at $17 per bushel at expiry, the $15 selling price from the contract means the rancher would have passed up an extra $2 per bushel profit.
Step by step instructions to Trade Commodity Futures
These days, trading commodity futures online is a straightforward interaction. All things considered, you ought to do a lot of due diligence before jumping in.
The following are a couple of moves toward take to assist you with getting begun:
- Pick an online commodity broker that fits your requirements (Interactive Brokers is an extremely well known commodity broker due to its wide selection of products, great service, and low commissions)
- Finish up the financial documentation required to open an account
- Fund the account
- Foster a trading plan that fits your personal risk and return targets
- Begin trading
At the point when you begin, try to utilize small amounts and possibly make one trade at an at once. Try not to overwhelm yourself. Overtrading can make you face undeniably more risk challenges you can handle.
The Commodity Futures Trading Commission (CFTC)
Commodity futures contracts and their trading are regulated in the U.S. by the Commodity Futures Trading Commission (CFTC), a federally-commanded U.S. regulatory agency laid out by the Commodity Futures Trading Commission Act of 1974.
The CFTC manages the commodity futures and options markets. Its goals include the promotion of competitive and efficient futures markets and the protection of investors against manipulation, abusive trade practices, and fraud.
Commodity Futures FAQs
Are Commodity Futures Contracts Transferable?
Commodity futures contracts are normalized to work with trading on an exchange. Yet, while they're effectively transferable, the obligation within the contract remains substantial.
For what reason Do Commodity Brokers Use Forward and Futures Contracts?
Both forward contracts and futures contracts are agreements to buy or sell an asset at a predetermined price at a specific date. In this way, commodity brokers use them principally to moderate the risk of fluctuating prices by "locking in" a price beforehand.
How Do You Report Commodity Futures Gains and Losses on Your Taxes?
The IRS requires a specific form while reporting gains and losses from commodity futures contracts: Form 6781. The IRS thinks about commodities and futures transactions as 1256 Contracts.
What Is the Commodity Futures Modernization Act?
The Commodity Futures Modernization Act (CFMA), endorsed into law on December 21, 2000, is U.S. federal legislation stating that over-the-counter (OTC) derivatives would remain unregulated.
- A futures contract likewise allows one to conjecture on the course of a commodity, taking either a long or short position, using leverage.
- A commodity futures contract is a normalized contract that obliges the buyer to purchase some underlying commodity (or the seller to sell it) at a predetermined future price and date.
- Commodity futures can be utilized to hedge or safeguard a position in commodities.
- The high degree of leverage utilized with commodity futures can intensify gains, as well as losses.
- The IRS requires a specific form while reporting gains and losses from commodity futures contracts: Form 6781.