Using commodities futures, business owners can set the selling pricing of their goods for months, years, or even over many weeks.
What are commodity futures?
Commodities are the raw materials. 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.
Commodity futures are derivative contracts in which the buyer commits to buying or selling a defined amount of a commodity at a predetermined price on a specific future date. Investments known as derivatives get their value from the cost of another asset, usually referred to as the underlying asset.
The spot price of the underlying mainly determines the price of the futures contract, but the delivery date, interest rates, and storage expenses also influence it.
Regarding how the underlying commodity prices will develop, buyers and sellers in the futures market hold differing views. The value of the underlying commodity at the time of the futures’ expiration will determine whether a buyer makes a gross profit or loss. Conversely, a seller will experience a gross profit if the value of the underlying drops at expiration and a gross loss if it rises. Most producers and users buy and sell commodities in the cash (spot) market because the total cash price is paid on the spot.
The fact that futures are settled every day makes them unique. The exchange that the future trades on establishes the closing market price at the end of each trading day.
How to trade commodity futures?
The best approach to trade commodities is to combine technical analysis with fundamental analysis. Technical analysts look at the futures market itself, including price behavior, trading volume, and open interest. Fundamental analysts try to determine the supply of a particular commodity and the corresponding demand.
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One of the approaches to investing in commodities futures is through commodity ETFs. Options include commodity mutual funds and commodities exchange-traded funds. These funds do invest in a variety of currently accessible commodity futures.
Commodity prices can change dramatically. In the market, fraudulent techniques are widespread. If you don’t know what you’re doing, you risk losing more money in the beginning than you invested.
Futures are bought and sold in commodity exchanges like NYMEX in the USA. The markets are monitored to ensure fair practices. US futures markets are regulated at three levels. Each exchange is an SRO responsible for its own operations and the conduct of its member firms. The National Futures Association (NFA) is the industry SRO responsible for overseeing the firms and individuals who trade for investors. It can discipline those who violate its rules of professional conduct.
The Commodity Futures Trading Commission (CFTC) is the federal regulator responsible for keeping markets competitive, transparent, and financially sound and ensuring that investors have the information they need to make informed investment decisions. You take part in the futures market through a managed account or a commodities pool rather than trading futures through an individual trading account.
How to minimize futures 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 must 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. These quantities are usually large to make the futures trading more efficient though they vary significantly by product.
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.
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.
What are the pros and cons of commodity futures?
Commodity futures determine the price of raw materials since they trade on an open market. They also forecast the commodity’s value in the future. Traders and their advisors set the prices. They spend the entire day researching their specific products. Forecasts rapidly include the day’s news and information.
Comparing pricing in different markets is easier because these contracts are regulated.
Hedging the price of a commodity on the futures market is an additional reason for doing so. Futures contracts are used by businesses to fix the pricing of the commodities they buy or sell. With these futures, producers, traders, and end users can reduce uncertainty by hedging against price fluctuations.
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 like gains on securities. As a result, you’ll want expert tax advice before trading futures and reporting gains and losses.
Trading (in these futures) benefits investors since it enables them to diversify their holdings. On the other side, these futures contracts have a high level of volatility. This is because events around the world impact commodity markets and price changes can happen anytime. Since most commodities will remain in demand for many years, there are plenty of opportunities to profit. The dangers are also great. Only those who can handle a lot of risks and keep up with world events that can affect prices should consider a career in commodity trading.
How Do Commodity Futures Work? Prices, Risks by Inna Rosputnia
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