Modern life depends on raw materials. In other words, the products that keep people and businesses going — so anticipating what they’ll cost, among other factors, fuels the futures market.

Commodities are the raw materials also. They are consumed in the process of creating food, fuel, clothes, cars, houses, and many other products that we buy — the wheat in bread, the silver in earrings, the oil in gasoline.

Most producers and users buy and sell commodities in the cash (spot) market because the total cash price is paid on the spot.

What determines commodity prices?

Supply and demand determine commodity prices. For example, if a commodity is plentiful, its price will be low. At the same time, if it’s hard to come by, the price will be high.

Supply and demand for many commodities follow seasonal cycles. For example, tomatoes are cheapest in the summer when they’re plentiful and most expensive in the winter when they’re out of season. So soup manufacturers plan their production season to take advantage of the highest-quality tomatoes at the lowest prices.

However, there are no 100% rules. So you have to consider many other factors before taking a trade. For example, suppose a drought wipes out the Midwest’s wheat crop, cash prices for wheat surge because bakers buy up what’s available to avoid a short-term crunch. Or, if political and economic turmoil threatens the oil supply, prices at the gas pumps jump in anticipation of supply problems.

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Minimizing future risk

Since people don’t know when such disasters will occur, they can’t plan for them. That’s why futures contracts appeared. They help businesses minimize risk. For example, a baker with a futures contract to buy wheat for $5.40 a bushel is protected if the spot price jumps to $6.85.

Farmers, loggers, and other commodity producers can only estimate the demand for their products and try to plan accordingly. But they can get stung by too much supply and too little demand — or the reverse. Similarly, manufacturers have to take orders for future delivery without knowing the cost of the raw materials they will need to make their final products. That’s why they buy futures contracts on the products they make or use: to transfer the risk of unexpected price bumps.

You find the market value of a commodity contract by multiplying the current price times the quantity of the underlying product covered by the contract. To make the futures trading more efficient, these quantities are usually large, though they vary significantly by product.

Consumable Commodities

Cash Prices as Clues

The fluctuation in cash prices provides clues to what consumers can expect to pay in the marketplace for products made from the raw materials.

Unlike the stock market, though, where a particular economic situation is likely to have a similar impact — up or down — on the equities being traded, in the cash market the price of each commodity operates independently of the price on others.

Futures prices tend to track cash prices closely, but not identically. The difference between the futures contract price and the cash price of the underlying commodity is called the basis.

The prices tend to change constantly, though rarely dramatically, from day to day. But during a period of several months or a year, you may find significant increases or decreases in some products and surprisingly little change in others.

Arbitrage

Some professional traders use arbitrage to capitalize on price discrepancies between futures contracts and underlying commodities. Using sophisticated computer programs to track price shifts, they can make money by simultaneously buying the one that’s less expensive and selling the one that’s pricier. Because they trade huge numbers of contracts very quickly, tiny price differences can result in major gains — or losses.

Since many arbitragers — or, more accurately, their programs — make the same decisions at the same time, their activity can affect prices in the markets where they trade.

Taxing issues 

There may be tax benefits from trading regulated futures contracts, which the IRS classifies as 1256 contracts. Sixty percent of gains on contracts sold during the tax year or held at year’s end are taxed at the long-term capital gains rate regardless of the period they were held. The remaining 40% are taxed as short-term gains. In contrast, all short-term gains on securities trades are taxed as ordinary income.

But the rules are complex. For example, gains on single stock futures are taxed the way gains on securities are. You’ll want expert tax advice before trading futures and when reporting gains and losses.

How Do Commodity Futures Work? Prices, Risks by Inna Rosputnia

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