An Introduction to Commodity Futures Market

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An Introduction to Commodity Futures Market

A commodity market is one of the few investment areas where a person or a firm with limited capital can gain great profits in minimum amount of time. For instance, an airline company can enter in this arena to get into an agreement with Fuel Company to purchase a fixed amount of jet fuel for a given price in a certain period of time which in turn would enable it to hedge against volatility associated with the price of jet fuel.

 

This market was introduced back in the early 1840’s when Chicago infrastructure of railways and waterways made it possible for the mid west farmers to meet with the dealers who were willing to ship their harvest to markets around the country. Making such deals became an essential exchange for farmers looking for the right place to sell their crops and dealers who need reliable source of grain. In the first place, the spot market was evolved as farmers looked forward to find a buyer that brought their grain to the Chicago market which in turn helped them to sell their product.

The first futures contract was mostly like an agreement between dealers and farmers who outlined purchase price and quantity of grain delivered by farmer at future date. Also in a short while, the speculators began trading in these contracts in the hope that laws of supply and demand would work for them.

By 1848, the Chicago Board of Trade (CBOT) founded by 82 Chicago merchants first settled into location above Gage and Haines flour store at 101 S. Water Street where it stayed until 1852. It is now an official organisation that helps farmers find buyers and provide for a robust trading marketplace.

Today, even though commercial users are the main players in the market, traders and investors also make use of it to profit from price volatility. Hence, following things need to be known before moving out in this market-

RISK
First thing that must be known is that this market is risky and only risk capital should be used to invest in it. Therefore one needs to be careful about any advertising or claims of potential for sizable profits in day trading.

COMMODITIES TRADING FUTURES CONTRACTS
A futures contract is a security between the parties who agree to buy or sell the asset of good quantity and quality at the settlement date and price. The party that buys the asset in such contract takes on a long position while the party selling it is on short position. Its price is set by the market forces of equilibrium between supply and demand of underlying asset as well as between competing buy and sell orders.

Example of assets under this are commodities like gold, oil or wheat as well as financial futures like currencies, securities or financial instruments.

FUTURES TRADING CONTRACT CODES
Every future contract involves a particular type of asset being traded and the month or the year when the contract is traded for. Following are the contract codes for months—

January- F
February- G
March- H
April- J
May- K
June- M
July- N
August- Q
September- U
October- V
November- X
December- Z

FUTURES TRADING SETTLEMENT
There are 2 types of settlement for fulfilling the contract given as follows—

Physical Delivery: It is used often with commodities and bonds. The amount of underlying asset mentioned in the contract is delivered by the means specified in it.
Cash Settlement: It is used when above method is not possible like with the index or interest rates. Its payment is made according to the terms of the contract.

COMMODITIES TRADING MARGIN REQUIREMENTS
Future contracts are often traded on margin whose requirements are the amount of collateral that a trader has to post to minimize the risk of them defaulting. The collateral is deposited in margin account.

CHARACTERISTICS OF CONTRACT IN COMMODITIES TRADING
In commodities trading a contract would specify—

Underlying asset or instrument
Type of settlement
Amount of units of underlying asset per contract
Currency in which future contract is quoted.
Grade of the deliverable
Delivery month
Last trading date
Minimum permissible price fluctuation

FUTURE CONTRACTS VERSUS OPTIONS
In futures contracts the buyer or seller has an obligation to deliver or take the commodity according to the terms of contract whereas in options he/she has the option to deliver or take the commodity by the terms of contract.

FUTURES TRADING REGULATION
Following are the futures trading regulations that one needs to know when moving about in the futures market—

Commodity futures trading commission (CFTC): The United States futures trading industry is closely regulated by CFTC which was created by Congress in 1974 to regulate commodity futures and option markets in US. Its regulations can be found out at Title 17 Chapter 1 of the Code of Federal Regulations (CFR).
National Futures Association (NFA): An independent, self regulatory organization for the US futures trading industry.

The above points tell us what the commodity markets consists of, but the intermediaries in the futures trading markets also need to be well known which in turn is required to register with the Commodity Futures Trading Commission (CFTC) and depending upon their activities are subject to many financial, disclosure, reporting and record keeping requirements. The intermediaries are given as follows:–

INTRODUCING BROKERS (IBs)
A future introducing broker is one engaged in accepting or soliciting orders for purchase or sale of any commodity for future delivery on an exchange who does not accept any money, securities or property to margin, guarantee or secure any trades or contracts that result there from.

FUTURES COMMISSION MERCHANTS (FCM)
It solicits or accepts orders for contracts traded on or subject to rules of exchange and in connection with such solicitation or acceptance of orders, money, securities or property to margin, guarantee or secure any trades or contracts that result or can be.

Having understood the basics of commodity markets, it is time to turn over to how the person can move along in this market which will discussed in the techniques given as follows-

ARBITAGE
It is one such technique that takes advantage of price discrepancies between different future markets. For eg in an arbitrage trade, a person can purchase and sell the crude oil futures contracts in various trading venues for the purpose of capturing discrepancies.

FUTURES COMMISSION MERCHANT
It is much like traditional stock brokerage house except that it is allowed to offer products that trade on the future markets.

OTHER TECHNIQUES
Commodity trading advisor (CTA): It is an individual or company licensed to trade future contracts on the person’s behalf.
Commodity pool operator (CPO): It is similar to CTA except that it can manage funds of multiple clients under one account.
Commodity indexes: It is a benchmark similar to Dow Jones industrial average or S&P 500 that tracks the basket of most liquid commodities.

A huge number of organizations make use of the above techniques for regulating the futures markets including the Securities and Exchange Commission, and Commodity Futures Trading Commission. These organizations monitor the markets to prevent fraud and manipulation of data and protect investors from such activity and once the person feels fully prepared he should find a particular broker through which he wants to participate in futures trading market.

Also in the book “The Future Game”, Professor Richard Teweless explains the functions of futures markets: “In addition to decreasing the costs of production, marketing and processing, futures markets provide continuous, accurate, well publicized price information and continuous liquid markets. Thus futures trading are beneficial to the public which ultimately consumes the goods traded in the markets without which the speculator futures market could not function”.

Finally after giving out complete overview of the commodity markets, one thing that needs to be kept in mind is that trading commodity futures and options involves substantial risk of loss. The recommendations mentioned are of opinion only and does not guarantee profits. Past performances are not indicative of future results as it is not a solicitation of any order to buy or sell but a current futures market view. Hence any statements of facts contained herein are derived from sources believed to be reliable but not guaranteed by accuracy.

 

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