The Role of Futures Contracts in Commodity Trading

Investors use commodity futures to hedge their positions in commodities. Using a commodity futures contract as leverage, investors speculate on the expected direction of the security movement through their short-term or long-term positions. Such leverage can amplify both the gains and the losses. In this article, we’ll try to understand the role of futures contracts in commodity futures trading in detail.

Commodity Futures Contracts: An Overview 

A commodity futures contract is an agreement between the parties to buy or sell a particular commodity at a future date at a specific price. The underlying cost of the trade and the amount involved are mentioned in the contract at the time of the agreement. Most contracts specify that the contract would stand fulfilled only with the actual commodity delivery. 

How Does a Futures Contract in Commodities Work?

A futures contract is a financial instrument in which the investors do not pay the total price or own the underlying asset. All they have to do is to deposit an initial margin to enter into a futures contract. The margin amount required to enter the contract is only a percentage of the contract’s overall value, known as the notional value.

Significantly, margin requirements differ based on the risk profile of the underlying commodity being promised to be traded at the agreed terms in future. Investors can calculate the notional value by multiplying the underlying price with the contract size.

Commodity futures contracts are highly leveraged instruments. Even small price fluctuations can have a huge financial impact, especially for futures contracts requiring relatively lower margin requirements.

Leverage is significantly lower in futures contracts, which require higher margins. Price fluctuations in a futures contract are measured in terms of tick size. This tick size calculates the overall tick value by multiplying the contract size with the tick size. The tick value measures the volatility associated with the contact.

Role of Futures Contracts in Commodity Trading

Let us understand the role of futures contracts in commodity trading.

1. Risk Management

Risk management is one of the most essential benefits of commodity futures trading. Investors opting for commodity futures can shield themselves against adverse price movements. Notably, the very design of commodity trading protects multiple stakeholders, such as farmers, traders, and manufacturers, from volatility. The expectation of stability in prices translates into stability in production activities.

2. Diversification

Commodity futures provide an additional asset class for portfolio diversification. Since commodities are not closely associated with the traditional asset classes of stocks and bonds, commodity futures can enhance your portfolio’s overall risk-return profile by providing the required hedging arenas.

3. Price Discovery

Commodity futures trading plays a crucial role in price discovery. The buying and selling of futures contracts is beneficial in determining the fair market price of commodities. The dynamics of demand and supply direct the market towards a fair price. All stakeholders benefit from such a price discovery mechanism.

4. Leverage

Traders engaging in commodity trading get to control prominent positions with relatively small amounts of capital. This leverage opens the doors for both growth in profits and containment of losses.

5. Flexibility

Commodity futures trading in its present form offers investors a high degree of flexibility. They get flexibility in terms of the durations for holding their positions. You can select more than one expiration date for your future contracts. Based on the short-term and long-term expectations from the market, this flexibility can translate into strategic advantage.

6. Liquidity

The commodity futures market is considerably liquid. This is because of the significant amount of trading activity involved. Large volumes of trades ensure that individual traders can engage in buying and selling without significantly impacting the prices.

7. Transparency

The functioning of the commodity futures market in India is pretty transparent. All the market participants have access to real-time pricing information. Transparency in the market promotes efficient price discovery promoting fair competition.

8. Risk Hedging

Investors use commodity futures trading for risk hedging. While hedging can safeguard you against uncertainties and volatility of the market, you could also miss out on favourable prices by locking your contract at a fixed price. Importantly, if you miscalculate the risks and somehow over the hedge, you would have to unwind and sell your contract at a loss.

Understanding the Market Cycle for Optimal Trading Strategy

Commodities regularly undergo cycles of crests and troughs, creating opportunities for both upward and downward price revisions. As an adept trader, you could capitalise on these price fluctuations to generate profits in the commodity market—most commodities traded in the commodities market experience these fluctuations.

When a particular commodity experiences a surge in demand, the manufacturer’s capital expenditure increases significantly. This prompts the manufacturer to increase the price of the commodity. As the prices rise, demand for the commodity wanes, forcing the company to scale back its capital expenditure. This results in a decline in the price of the commodity.

As an intelligent investor, it is your prime responsibility to keep track of the cyclical nature of the commodities they are interested in trading. You could execute the trades at reasonable prices by keeping track of the cyclicity.

You can create opportunities to earn high profits and minimise losses by keeping track of the market’s cyclical nature.

Understanding Futures Commodity Trading: An Illustration

A farmer expects to produce 100000 bales of cotton in the next twelve months. Please note that futures contracts of cotton are traded in terms of 100 bales. The breakeven point for the farmer is Rs. 50,000. That is, the minimum price required to cover the cost of production is Rs. 50,000.

The farmer would want to settle for a contract price exceeding Rs. 50,000. Following the opportunities in the market, let’s say the farmer is able to settle for a one-year futures contract currently priced at Rs. 60,000 per barrel. In this case, the farmer would require1000 contracts.

Conclusion

Investors use futures contracts in commodities to bypass volatility. They agree to sell or purchase a particular quantity of a commodity at a specific price at a certain date in the future. This article shows how commodity futures trading plays a crucial role in shielding investors from uncertainties. We’ve seen how this trading is beneficial for multiple market stakeholders.