Commodity Futures – Meaning, How it works, Trading Process & more
The term Commodity Futures have gained a lot of recognition in the commodity market in the past few years. However, the concept of future trading has its root dug deep back in time.
It is said that there was a cotton futures exchange in 1875 too. But the authorities decided to put a ban on futures trading in case of essential commodities. This step was taken to avoid speculative activity and price hoarding.
Although, the concept of commodity futures was reintroduced in the year 2002, after which it started gaining a lot of significance in the commodity market.
What are Commodity Futures, and How they work?
Futures are a form of derivates, which means the value of futures is derived from underlying security value. In the case of futures, the value of an underlying asset is pre-determined. Let us try to understand the concept of futures with an example.
Suppose a farmer has produced 100 quintals of rice and wants to sell it at a rate of Rs.2000 per quintal. Due to the high volatility in the market, the prices fluctuate, and the farmer does not know if he will be able to sell the produce at Rs.2000.
To hedge himself against the price volatility, he gets into a future contract. Under this, the farmer agrees to sell the produce after a month, but the prices are fixed on entering the contract.
On the date of expiry of contract there can be two possibilities:
1st – Due to some reasons, the prices of rice fell to 1500 per quintal. Since the farmer has already sold his produce at the rate of 2000, he will not be affected.
In fact, by entering into a futures contract, he could sell it at a price greater than the existing price in the market.
2nd – The prices of rice shot up and went to 2500 per quintal. But now the farmer won’t be able to sell his produce at the market price as he will have to cater to the futures contract.
Therefore, the farmer ends up selling 100 quintals for 2000 rather than the market price of 2500.
However, the above-quoted example was from a producer’s point of view to explain the futures contract’s core concept.
In case of future trading, profits and losses might be made differently, but the concept remains the same
In a nutshell, the commodity futures are contracts under which the traders get into an agreement to buy or sell a commodity at a price somewhere in the future.
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Trading in Commodity Futures
Before getting to know about the mechanism of trading in commodity futures, we must know the basics of trading in commodity futures.
In India, commodity futures are traded in two major commodity exchanges that are NCDEX and MCX.
While trading in a commodity, there is a prescribed lot, and you can only buy in multiples of that lot.
For instance, if a commodity has 10 quantities, you can buy in multiples on ten only. Starting with commodity trading can be slightly more complicated than equity trading.
In this case, you are given a certain margin, and you must have that much margin available for trading. If you want to make a trade worth 1 crore and the margin is 4%, you should have 4lakhs in your account to execute the trade.
If you are buying a futures contract, you also have an option to get the physical delivery of the commodity when the contract expires. Else you can square it off.
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Trader’s Mindset in Commodity Futures
A trader’s mindset is completely different from that of a producer. Therefore, the tendency to book profits and losses is different too.
Most traders in the market buy with the intention to buy the future at low prices and selling when the price rises.
But the example we discussed did not cover how trading in commodity futures takes place. Let us try to find out with the help of an example.
A trader bought a certain quantity of Crude Oil when the market fell near March. This would have been a smart choice as it was the right time to buy as all the securities were sold at low prices.
Let us assume the trader gets into a crude oil future contract with May 2020 expiry at a price of 2000 per barrel, and the lot size is 5000 barrels.
When the markets across the globe started recovering, their consumption of crude started increasing.
This would lead to a rise in the price of crude. Let us assume the price shot up to 2500 by the time of expiry.
Therefore, the trader gets to sell the contract at 2500 per barrel and book a profit of 500 per barrel. Since the lot size is 5000 barrels, the total profit would be 25 lakhs.
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Advantages of Trading in Commodity Futures
Commodity futures have become an important element of trading in the commodity market. Let us understand the reason by looking at the advantages of trading in commodity futures.
Leverage: The margin required and leverage is inversely proportional. This is because the leverage is calculated based on margin.
If the margin is 4%, this means that you can execute an order by just using a margin of 4%. In other words, the value of the trade you execute is 25 times the money used as margin.
These 25 times is the leverage in this case. Since the margin is low in commodity futures, you can trade by paying a lesser amount.
Price Discovery: The concept of Economics tells us that the price is derived from the intersection of demand and supply.
This law holds true in the case of commodities too. However, with the help of future trading, we can analyze the future price of a commodity.
To do this, take into consideration the level of demand and supply at that time.
Hedging: As discussed in the example, if you are a producer, you may use commodity futures for hedging. Hedging is done to protect the trader from volatility leading to price fluctuations.
Diversification of Portfolio: Adding commodities like gold can help in diversifying the portfolio and making it shock resistant.
This is because gold generally moves in the opposite direction of most commodities. Therefore, in economic slowdowns, the price of gold tends to rise, which helps in hedging your portfolio against the loss due to fall in other securities.
Disadvantages of Trading in Commodity Futures
There are multiple reasons because of which it is said that new traders should not enter commodity markets. In fact, some experienced traders avoid trading in commodity futures.
Let us know the reasons by looking at the disadvantages of commodity futures.
Volatility: Since the price of a commodity is affected by a variety of factors, there can be a lot of price fluctuations.
A commodity is not only affected by the factors in the domestic market, but the changes happening across the globe will affect future contracts in India commodity markets too.
Effect of price change: If a producer gets into a futures contract and the price of commodity increases, he will not be able to reap the benefits.
Therefore, the producer sells the produce at a price lesser than the market price.
Leverage: The amount of leverage provided by the broker can act as a disadvantage too. This is because higher leverage has a higher level of risk associated with it.
So, if your trade does not go right, you might end up losing a lot of money due to higher leverage.
Conclusion: Commodity Futures
Trading in commodity futures can be a great way of earning profits for traders, provided you do things the right way.
We will now sum up the entire concept of trading in commodity futures by mentioning the important points.
- In the 1960s, futures trading in case of essential commodities was banned as the authorities feared that there was a risk of speculation.
- In the year 2002, the concept of futures trading in the case of commodities came back into existence. Since then, it has gained a lot of popularity among those who wish to trade in commodities.
- Futures are a form of derivatives. As the name suggests, derivatives are the ones that derive their value from the price of an underlying asset. Therefore, any price movement in the value of that asset will affect the derivative too.
- Futures trading is an instrument under which the seller agrees to sell a commodity at a point in the future. However, the price for that is fixed at the time of entering into the contract.
- Future trading can be done by producers to hedge themselves against any unexpected fall in the price that might arise in the future.
- While trading in futures, the trader gets high leverage from the broker. This can be a boon if the trade goes right as you can earn high profits. However, if the trade prices change against your trade, you end up losing a lot of money.
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