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 in the future. These contracts can be employed for various purposes—to hedge an investment position or to speculate on the price movements of the underlying asset.
Many investors confuse futures contracts with options contracts. However, in futures contracts, the holder is obligated to act. Unless unwound before expiration, the holder must either buy or sell the underlying asset at the agreed price.
Commodity futures differ from trading in the spot commodities market.
Key Takeaways
- A commodity futures contract mandates the buyer to purchase, or the seller to sell, an underlying commodity at a set future price and date.
- Used to hedge investment positions or protect against unfavorable price changes.
- Leverage allows amplifying both potential gains and losses.
- Reporting gains or losses requires IRS Form 6781.
How a Commodity Futures Contract Works
Most commodity futures are closed out or netted at their expiration date with the price differential being cash-settled. They allow positions in commodities such as:
- Crude oil
- Wheat
- Corn
- Gold
- Silver
- Natural gas
Futures contracts are identified by their expiration month. Contracts for some commodities exhibit significant price volatility, yielding potential for high gains or losses.
Commodity futures and forward contracts are similar, but futures are regulated and standardized while forwards are OTC and customizable.
Speculating with Commodity Futures Contracts
Traders use these contracts to speculate on price movements. This can involve going long or taking a short position using leverage, meaning that only a fraction of the total trade amount must be deposited.
For example, with an initial margin of $3,700, an investor acquires a futures contract for 1,000 barrels of oil valued at $45,000 (with oil priced at $45 per barrel). If oil prices rise to $60 a barrel, the investor earns a significant profit.
However, the leverage involved makes futures trading high-risk and is best suited only for those with high risk tolerance and understanding.
Risks of Commodity Speculating
The obligation to purchase or sell the underlying asset means that unopened positions could result in large, unwanted deliveries. Commodity futures trading involves significant risk due to potential high leverage. A losing position can trigger a margin call for additional funds to shore up the account.
Hedging with Commodity Futures Contracts
Businesses enter into futures to secure prices of assets they use or sell. Hedging aims to avoid losses from price swings rather than for speculation. Companies commonly using hedges include farmers, oil producers, and manufacturers.
For instance, a plastics producer might hedge the price of natural gas. If prices rise, the hedge profits offset increased costs. However, hedging can also lead to missed opportunities for price gains.
Risks of Commodity Hedging
Hedging can make companies miss favorable price movements. Over-hedging leads to losses when unwinding downside positions.
Pros and Cons
Pros
- Leverages margin accounts.
- Opportunities for both speculative gains and cost control.
- Hedging controls cost for vital commodities.
Cons
- Leverages can amplify losses and trigger margin calls.
- Fixing prices might miss potential gains.
- Over-hedging can lead to losses.
Example of Commodity Futures
Business owners utilize futures contracts to pre-set selling prices.
Example: A farmer anticipates producing 1,000,000 bushels of soybeans over 12 months, and each futures contract represents 5,000 bushels. The farmer decides to use futures priced at $15 per bushel to lock in prices, securing necessary returns irrespective of market fluctuations.
Steps for Trading Commodity Futures
To start trading commodity futures online:
- Choose a suitable online commodity broker.
- Fill out necessary financial documentation.
- Fund your account.
- Create a trading plan matching your risk and return goals.
- Start trading.
Starting small and gradually increasing investments is key to manage risk effectively.
The Commodity Futures Trading Commission (CFTC)
Commodity futures in the U.S. are regulated by the CFTC, ensuring competitive and fraud-free markets.
Commodity Futures FAQs
Are Commodity Futures Contracts Transferable?
Yes, they are standardized for exchanges but the contract obligation remains.
Why Use Forward and Futures Contracts?
To mitigate price fluctuation risks by locking in prices beforehand.
Reporting Gains and Losses on Taxes
Use IRS Form 6781 for reporting.
What Is the Commodity Futures Modernization Act?
The Act allows OTC derivatives to remain unregulated.
Related Terms: options contracts, spot commodities, forward contracts, leverage, margin call.
References
- Commodity Futures Trading Commission. “History of the CFTC”.
- Congress.gov. “H.R.5660 - Commodity Futures Modernization Act of 2000”.
