Using commodity futures, business owners can lock in the selling prices of their goods for months, years, or even extended periods. This helps them manage price risk and stabilize their revenue.
What are commodity futures?
Commodities are raw materials used in producing various goods such as food, fuel, clothing, cars, and houses—like the wheat in bread, silver in jewelry, or oil in gasoline.
Commodity futures are derivative contracts where the buyer agrees to purchase or sell a specified amount of a commodity at a predetermined price on a future date. These derivatives derive their value from the underlying asset’s cost.
The price of a futures contract is primarily influenced by the spot price of the underlying commodity, but factors such as the delivery date, interest rates, and storage costs also play a role.
In the futures market, buyers and sellers have differing expectations about how the price of the underlying commodity will evolve. The outcome at the contract’s expiration will determine the profit or loss: buyers will profit if the commodity’s value rises, and incur a loss if it falls; sellers will profit if the value drops and incur a loss if it rises. Most producers and consumers prefer to buy and sell commodities in the cash (spot) market, where the total price is settled immediately.
What makes futures unique is their daily settlement process. Each trading day, the exchange determines the closing market price, which is used to settle positions.
How to trade commodity futures?
The most effective approach to trading commodities is to combine technical and fundamental analysis. Technical analysts focus on the futures market’s price behavior, trading volume, and open interest. In contrast, fundamental analysts assess the supply and demand dynamics of a particular commodity to gauge its market potential.
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One approach to investing in commodity futures is through commodity ETFs, including commodity mutual funds and exchange-traded funds. These funds invest in a range of available commodity futures.
Futures are traded on commodity exchanges like NYMEX in the USA, which are regulated to ensure fair practices. US futures markets are overseen at three levels: each exchange is a self-regulatory organization (SRO) responsible for its operations and member firms; the National Futures Association (NFA) oversees firms and individuals and can discipline those who breach its professional conduct rules.
The Commodity Futures Trading Commission (CFTC) is the federal regulator tasked with ensuring that futures markets remain competitive, transparent, and financially sound. It also works to ensure that investors have the necessary information to make informed decisions.
To participate in the futures market, you may use a managed account or invest through a commodities pool, rather than trading futures directly through an individual trading account.
How to minimize futures risk?
Because it’s difficult to predict when disasters or significant price changes will occur, futures contracts were created to help businesses manage risk. For instance, a baker with a futures contract to buy wheat at $5.40 per bushel is protected if the spot price rises to $6.85, ensuring they don’t face unexpected cost increases.
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 place orders for future delivery without knowing the future cost of the raw materials they need. To manage the risk of unexpected price fluctuations, they use futures contracts on the products they produce or require, effectively transferring the risk of price volatility.
To determine the market value of a commodity contract, multiply the current price by the quantity of the underlying product specified in the contract. While these quantities are typically large to enhance trading efficiency, they can vary significantly depending on the product.
Arbitrage
Professional traders often use arbitrage to exploit price discrepancies between futures contracts and the underlying commodities. By employing sophisticated computer programs to monitor price movements, they can simultaneously buy the cheaper contract and sell the more expensive one. This strategy can yield significant gains—or losses—due to the rapid trading of large volumes of contracts, even when price differences are small.
Since many arbitragers, or more accurately their algorithms, make similar trades at the same time, their actions can influence prices in the markets where they operate.
What determines commodity prices?
Commodity prices are largely driven by supply and demand. When a commodity is abundant, its price tends to be low, whereas a scarce commodity will command a higher price.
Many commodities experience seasonal price fluctuations. For instance, tomatoes are generally cheaper in the summer when they are plentiful and more expensive in the winter when they are out of season. Soup manufacturers often plan their production schedules to benefit from the best quality tomatoes at the lowest prices.
However, these trends are not foolproof. Other factors must be considered before making trading decisions. For example, a drought that devastates the Midwest’s wheat crop can cause a surge in cash prices as bakers scramble to secure supplies. Similarly, political or economic instability that threatens oil supplies can lead to higher gas prices as consumers anticipate potential shortages.
What are the pros and cons of commodity futures?
Commodity futures play a crucial role in determining the price of raw materials by trading on open markets and forecasting future values. Traders and their advisors set these prices through extensive research and by incorporating daily news and information. Since these contracts are regulated, comparing prices across different markets is more straightforward.
Futures contracts are also used for hedging, allowing businesses to lock in prices for the commodities they buy or sell. This helps producers, traders, and end users manage risk and reduce uncertainty related to price fluctuations.
There may be tax benefits from trading regulated futures contracts, which the IRS classifies as 1256 contracts. Gains from these contracts are taxed at 60% long-term capital gains rate and 40% short-term gains rate, regardless of the holding period. However, tax rules are complex, and gains from single stock futures are taxed similarly to securities. It is advisable to seek expert tax advice when trading futures and reporting gains and losses.
Investing in futures can benefit those looking to diversify their holdings, though the market is highly volatile due to global events influencing commodity prices. Despite the risks, the ongoing demand for commodities provides ample opportunities for profit. Therefore, only those comfortable with significant risk and staying informed about global developments should consider a career in commodity trading.
How Do Commodity Futures Work? Prices, Risks by Inna Rosputnia
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