This is part of an introductory guide to commodities trading. For more in-depth analysis, visit Agricultural Commodities Focus, a monthly research series on agricultural commodity trading.
What are commodities futures
A commodity futures contract is a standardized agreement to either buy or sell a predetermined quantity of a commodity at a specified price on a future date. These contracts serve various purposes, including hedging to protect a physical position or speculating on the anticipated directional movement of the underlying commodity.
It's important to distinguish commodity futures contracts from options contracts. In the case of futures contracts, the holder bears an obligation to take action. If the holder does not unwind the futures contract before its expiration, they are obligated to either buy or sell the underlying asset at the agreed-upon price.
What drives the prices of commodities futures
As with most financial markets, the commodities futures market can be volatile. What drives the long term price movement of commodities futures?
Doug Christie, an agribusiness executive and author of Agricultural Commodities Focus, said during an interview, “Over the long run, supply and demand fundamentals are what drive prices and ultimately determine where things settle.”
Research studies consistently suggest that almost all of the price movements are driven by fundamentals. However, there's always some short term noise from hour-to-hour, day-to-day that is probably driven by non-fundamental factors.
“In the short run there can be a lot of volatility around those same supply and demand fundamentals while the market's trying to weigh and sort out where the final resting spot may be,” said Christie.
Why trade commodity futures
Commodity futures are used by buyers and sellers to “lock in” a pre-determined price, either for hedging purposes or speculation. In this market, participants can be broadly categorized into two main groups.
The first group is commonly known as the "commercial" participants. The primary objective of commercial participants is to hedge potential losses arising from unfavorable price changes, rather than engaging in speculation. Many companies employing hedging strategies are directly involved in the production or utilization of the underlying asset of a futures contract. For example, a soybean farming company may choose to hedge the risk of falling soybean prices and lock in their profit by selling a futures contract in soybean.
The second group of participants consists of institutional investors and money managers.
“These are people who may not participate in the physical flow of commodities, but are regular participants in the market as a financial trading opportunity,” said Christie. “This group includes brokerage houses, investment banks, and private equity funds.”
These participants frequently utilize futures contracts to speculate on commodity prices. Commodities often display significant price volatility, indicating substantial fluctuations over short periods. Such volatility creates opportunities for significant profits (or losses) for these participants.
Information sources for commodities
In contrast to the stock market, where companies serve as the primary source of information through financial reports and SEC filings, the agricultural commodities market relies on the U.S. Department of Agriculture as the primary resource for market participants. The USDA maintains historical global supply and demand tables for the major commodities and this archive is the statement of record used by traders.
“Agricultural data is organized by crop year,” said Christie. “By convention, the crop year begins at the onset of harvest of a crop and concludes 12 months later.”
“While the actual timing of harvest will differ from year to year, a standard crop year convention is always applied.”
By examining the supply and demand data published by the USDA, traders can form a view on the price direction of the relevant commodity.
How futures contracts are settled
Most commodity futures contracts are settled or netted at their expiration date. The cash settlement is based on the price difference between the original trade and the closing trade. Commodity futures are often used to establish a position in an underlying commodity. Common commodities include:
- Wheat
- Corn
- Soybean
- Crude oil
Commodity futures contracts are identified by the expiration month in their name, signifying that a contract concluding in September is a September futures contract. Certain commodities exhibit considerable price volatility or fluctuations. Consequently, there exists the potential for substantial gains but also significant losses.
Risks of commodity speculation
In contrast to options, futures entail the obligation to either purchase or sell the underlying asset. Consequently, failing to close an existing position may lead an inexperienced investor to take delivery of an undesirable quantity of commodities.
Engaging in the trading of commodity futures contracts can be very risky for beginners. The leverage associated with these contracts can magnify both gains and losses. In the event of a losing futures contract position, the broker may issue a margin call, demanding additional funds to support the account. Typically, approval for margin trading is required from the broker before entering into such contracts.
How to trade commodity futures
Trading commodity futures online has become a straightforward process in today's digital era. Nevertheless, it is crucial to conduct thorough research before diving into this market.
Follow these steps to help you get started:
- Select an online commodity broker that aligns with your requirements.
- Complete the necessary financial documentation to open your trading account.
- Fund your account.
- Develop a trading plan tailored to your individual risk tolerance and return objectives.
- Initiate trading activities.
As a beginner, consider using small amounts and limit yourself to one trade at a time if possible. Avoid overwhelming yourself, as overtrading can expose you to more risk than you might be equipped to handle.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.