Buying Commodities Without Needing to Buy Them
Futures contracts involve an agreement between two parties, involving the promise to deliver a certain amount of goods or other things of value, at a certain time, in a certain quantity, and for a certain price.
These contractual arrangements are known as “futures”. Futures are always an arrangement set to occur in the future, as opposed to buying commodities or other assets that are traded on the market for cash, on the spot market in other words.
If you are looking to buy gold for instance, you can either buy it now on the spot market, or from a dealer who bases their prices upon the current price for an ounce of gold, plus whatever premium they will charge, or you can buy gold in the future at a price which will be paid in the future, on the futures market.
Futures usually consist of contracts to buy and sell physical goods, known as commodities, and it is only things of a fairly uniform standard, where one lot of it isn’t meaningfully different from another, that qualify as commodities.
There are several categories of commodities that are traded on the futures market. They include metals such as gold, silver, platinum, and copper, energy, including crude oil, heating oil, gasoline and natural gas, livestock and meat, including lean hogs, pork bellies, live cattle, and feeder cattle, and agricultural products, including corn, rice, soybeans, cocoa, coffee, wheat, cotton, and sugar.
Futures contracts involve larger lots, these aren’t deals that people enter into to just buy a few of these items, for instance you can’t get a futures contract for just an ounce or a few ounces of gold, you would buy one for 100 ounces, or at least control that much for purposes of price changes.
There are other types of assets that are traded on the futures market, for instance currencies, treasury bonds, and stock indexes are things you can buy down the road as well. With stock indexes, this would consist of a basket of stocks representing a certain index, the S&P 500 for instance. You can even buy futures on things like cellular bandwidth these days.
Most trading in futures is done on exchanges, but there are some contracts that occur over the counter, between the participants directly, which are called forward contracts. Futures started out as the forward market until things got more organized, but these forward deals still go on.
Why Trade in the Futures Market?
All of the commodities that are traded in futures have some business use. Even the metals do, even though with the precious metals, they are often traded as stores of value and not as business inputs. This business or industrial use forms the underlying basis of these trades, as there are parties who have reasons to want to either get a certain price for their business goods down the road, or want to lock them in to buy later at a certain price.
This serves to hedge the cost of doing business, and in order to ensure that these deals are as competitive as they can be, they trade on the market. This also allows those who are looking to actively participate in the distribution of these goods to enter into contracts at any time during the life of the contract, as needed or desired.
The price of futures contracts are based upon the current price for the item, plus whatever price changes in it are anticipated during the duration of it. There are many factors involved which affect the expected price, but it all really comes down to supply and demand, as it does with all financial trading.
Both the supply and demand affects price, and with commodities, factors peculiar to the business cycle of the commodity itself may come into play, such as poor weather affecting growing seasons and the like.
In addition to people looking to reduce their risk of price fluctuations with goods that they trade in, many people use the futures market to speculate. Speculators do not trade in futures with the intention of ever taking possession of the items in the contract, they do so instead to seek to make a profit by looking to hold the contracts to be sold later.
So typically, a speculator would exit the contract prior to it being settled, although most future contracts settle in cash, to make the market more liquid. Some contracts do specify that delivery must be made, and these are not ones that speculators will keep until expiration.
Hedgers and speculators both serve a purpose in the futures market, with hedgers looking to reduce the risk that they will pay more, and speculators looking for the value of the contract to rise in price, if they are long that is, and make a profit that way.
Speculators keep the contracts very liquid, as they change hands a lot in the market, and this also helps hedgers get involved any time they like, on both ends, either entering or exiting. Futures not only benefit people looking to invest, they also benefit the businesses that use this market, and allow for market forces to determine the best price with the least risk for their goods.
Trading in the Futures Market
Given that the futures market is so liquid, one can enter and exit positions with relative ease, so investors do not worry about getting stuck having to take delivery of commodities at the end of contracts. It’s easy to simply sell the contract on the market.
Investors can also roll over contracts, which means that they roll over the current contract they have into a longer one. This way investors can stay invested in the contract for longer periods than just a single contract of a given length, if desired. This also provides them a means where they do not have to take delivery should the contract require that.
The futures market works a lot like the stock market, with the financial instruments trading either on the exchange floor or electronically, based upon the bid and ask system. This serves to minimize the gap between buyers and sellers, called spreads, and ensures market efficiency.
Unlike other financial securities, futures contracts settle at the end of each business day, meaning that profits and losses are applied to both sides of the contract. This settling helps assure that all parties are able to meet their financial obligations at the end of the contract, and is the main reason behind almost all futures contracts settling in cash, as they settle in cash not just at the end but every day.
So after the contract is concluded, instead of taking delivery, the buyer would have the difference between the agreed upon price in the contract and the current price in his account, and then could just go buy the goods on the market, being compensated for the price movement if the price went up. The seller would settle on the difference in price as well.
Speculators make and lose money the same way with futures contracts, and if you speculate the price will go up or the price will go down and you’re right, you make the difference between the agreed upon price and the current price, and vice versa. This is how you lose money as well, if you are on the wrong side of the price change.
Speculating in Futures
Futures contracts are leveraged, meaning that you can buy these contracts on margin, much like you can buy stocks on margin. So there is a certain amount of money that you will have to both put up initially to enter into a futures contract, as well as an amount you need to maintain in your account, the maintenance requirement.
The ability to trade on margin makes trading in futures accessible to even smaller investors, and although a futures contract generally requires you put up one or more thousand dollars, there are contacts that can be entered in for as little as a few hundred dollars, with mini and micro contracts.
The futures market does want to make it accessible to investors of all sizes, including small ones, because to exclude them would be to miss out on trading opportunities and therefore reduce the liquidity of these markets.
Thanks to the efficiencies of electronic trading, this has opened the door to smaller investors, and there are contracts you can enter into now which only involve less than $200 to enter and maintain your position.
Due to buying on margin, one typically controls 10 to 20 times the size of their investment in the asset being traded, and while this isn’t anywhere near as much leverage as forex trading, currencies are much more stable than futures, and the margin requirements are there to protect investors from losing all of their money under reasonable market conditions at least.
Futures trading still has a greater degree of risk than trading in things like stocks and bonds though. It is important therefore to be aware of the risks of futures trading and not overly expose yourself. One can both make and lose a fair bit of money in futures, and it’s nice to win but you want to make sure you are not overly hurting yourself when you lose a trade.
For those who like to shoot for an even higher degree of risk and reward, you can trade in options with the future market, and given that this is an option, which is riskier in itself, to trade in a market which is already higher risk, this gives those who like to really take risks all they can handle.
Of course, risk is a relative thing, relative to your overall portfolio, and even the riskiest trades may not represent much risk to you if they constitute a small enough percentage of your overall portfolio. That’s important to realize in financial risk management, and futures trades can certainly add some real spice to your portfolio if managed well.