By Tamta Suladze
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A Brief Introduction To The Commodity Futures Trading

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A Brief Introduction To The Commodity Futures Trading

Commodities and derivatives trading has increased recently, with futures contracts accounting for the largest share in derivatives. This article will discuss what a commodity future is and how it works. We will also talk about commodity liquidity and the most traded commodities globally. 

Key Takeaways

  1. Commodities are physical substances that can be purchased or sold in markets.
  2. Commodity futures can be grouped into food, metals and energy products.
  3. The liquidity of a specific futures product can be measured by its daily trading volume.
  4. Commodity futures are traded on the futures market and are settled daily.
  5. Commodity trading is standardised and highly regulated.

The Definition of Commodity Futures 

Products that may be traded freely between buyers and sellers are called commodities. Physical supply and demand affect commodity prices. 

Commodity futures are a kind of asset-backed futures contract.

Agreements to buy or sell a raw material at a future date and price are known as commodity futures contracts. The contract specifies the total money to be paid, the selling price, and the delivery date. Instead of physical delivery, certain contracts provide for monetary settlement. 

Forward contracts, which farmers have used for centuries to exchange their goods, are the ancestors of today’s futures contracts. One of the first exchanged goods was probably agricultural products. 

The potential for noncompliance by one party to a forward contract is known as default risk or counterparty risk. 

Futures contracts, standardised, exchange-traded contracts that are simple to trade were developed to mitigate this danger. 

Commodity futures contracts became popular, particularly for petrochemicals, energy, and industrial metals.

Today, commodity futures can be grouped into three major categories:

  • Food – This category includes crops, meat, sugar and other food products or raw food materials suitable for further processing.
  • Metals – This type includes precious metals, such as silver, palladium, gold, silver, platinum, and copper.
  • Energy products – This type includes crude oil, gasoline, gas, and electricity. This is one of the most active and speculative markets.

Commodity Liquidity

Liquidity is a crucial element of any market. Commodities are more unstable than other types of investment, so liquidity in the commodity futures market is of prime concern. The liquidity of a specific futures product can be measured by its daily trading volume and the number of open positions, both long and short. The higher the volume, the more liquid a market is.

Different commodities have different degrees of liquidity. 

Thus, gold is the most liquid precious metal since it shows more trading activity than any other metal. Gold is traded in different markets such as OTC forward, physical market and swap market. There are also liquid gold futures and options contracts on futures exchanges. Other precious metals are less liquid; some, like rhodium, can be traded only in the physical market. All this makes gold liquidity higher than that of other metals since there are no rhodium futures.

Another example can be crude oil. It is the commodity that is traded with the largest volume worldwide. Coal, on the contrary, does not trade as widely or with as many derivatives as crude oil. So, compared to coal, crude oil is a more liquid energy resource.

How Do Commodity Futures Work?

Prices for commodities and contracts tend to fluctuate weekly, if not daily, basis. Futures contracts allow purchasers to lock in a certain price for a commodity and hedge against price increases. Commodity sellers use futures contracts as a hedge against price declines and an assurance of payment.

The buyer of a futures contract stands to gain if the value of the underlying commodity rises, since they can sell their goods at a greater price than the one initially agreed upon when they bought the contract.

In fact, the futures seller benefits from a price drop since they can acquire commodities at a discount and resell them at the predetermined markup.

One distinctive feature of futures is that daily settlement is the norm. The closing market price for futures after each trading day is set by the exchange on which they are traded. The daily mark-to-market (MTM) price is the same for everyone. Until the contract’s end date or the position is closed, mark-to-market settlements will occur every day.

Commodity futures are traded on the futures market. In this case, it is not the product itself that acts as collateral but the guarantee — a certain amount of money (usually 10-40% of the contract value), which is blocked on the account when opening a futures contract. When a position is closed, the specified amount is unfrozen.

The work of commodity futures trading is best explained with an example: let’s assume that an oil producer plans to produce 1 million barrels of oil and sell it next year. The current crude oil price is $50 per barrel. 

Given the high volatility of oil prices, the market price in a year could differ significantly from the current price. If the producer believes that the oil price will decrease in a year, they can freeze the price at $50 by entering into futures contracts for the corresponding amount of oil. Thus, by entering into futures contracts, the producer undertakes to deliver 1 million barrels of oil at $50 per barrel in a year, receiving $50 million as a result of sales.

Where Commodity Futures Are Traded

Future contracts are commonly traded on a commodities futures exchange. 

The largest futures markets are:

  • The Chicago Mercantile Exchange (CME) is the world’s largest derivatives exchange.
  • ICE (Intercontinental Exchange) — an American company founded in 2000 that manages many financial and commodity platforms and exchanges.
  • Eurex — an international exchange primarily offering derivatives transactions on the European market.
  • Chicago Board of Trade (CBOT) — the world’s oldest futures and options exchange.
  • The New York Mercantile Exchange (NYMEX) — the world’s leading derivatives marketplace and a commodity futures exchange
  • London Metals Exchange (LME) — leading global commodity exchange specialising in non-ferrous metals trading.

Commodity exchanges are controlled by higher authorities to ensure fair trading. Thus, the Commodity Futures Trading Commission (CFTC) regulates CME, CBOT and NYMEX. The Commission protects society from manipulation, fraud, and abusive practices associated with the commodity, financial futures and options sale. It also encourages competitive, open, and financially healthy futures and options markets. Buyers and sellers must register with the Commodity Futures Trading Commission to trade on the mentioned exchanges.

Commodity trading is very organised and on commodity exchanges. Thus, the contracts on an exchange are highly standardised: their price, quantity, quality, and time are determined by the exchange in which they are traded. 

The critical role of the exchange is to provide a safer trade. 

The contracts are processed in the exchange’s clearinghouse; the clearinghouse technically buys and sells all contracts. 

By making contracts fungible, the exchanges facilitate the purchasing and sale of contracts, which implies that the contracts are interchangeable. However, they must be for the same good in quantity, quality, and commodity and for the same delivery place and month.

Advantages And Disadvantages of Commodity Futures Trading

Commodity futures trading can be highly beneficial, though it is associated with certain risks and requires high expertise and profound trading knowledge. Here are some advantages and downsides of commodity futures trading.

Advantages Of Commodity Futures Trading

  • Standardisation – Commodity futures contracts are standardised and regulated, making it easier for a trader to compare global prices in markets.
  • Hedging – Commodity futures provide hedging against fluctuations in prices. This enables investors to safeguard their portfolios and eliminates uncertainty for traders, commodity producers, and end-users. 
  • Benefits for investors – Investors can diversify their portfolios by trading commodity futures, thus protecting their funds against market instabilities.
  • Arbitrage – Traders can profit from price differences. Plus, they do not have to pay the contract’s full value: to start futures trading, only the initial margin should be paid.

Disadvantages Of Commodity Futures Trading

  • Volatility – The commodity futures market is highly volatile since it is influenced by various events worldwide, such as economic crises, wars, or natural disasters. This results in price changes that can happen anytime.
  • Speculation – Speculators can artificially inflate prices by taking over a commodity market.
  • Over-leverage – The commodities futures market is risky due to its increased leverage, meaning the chances of gaining high profit and losing all your money are almost equal.

Top 5 Most Liquid Commodity Futures

Though a lot of commodities from various sectors are constantly traded in the futures market, some keep holding top positions from one year to another. Let’s take a closer look at some of such commodities.

Crude Oil 

Crude oil futures are the most efficiently traded futures in the global market. 

Though the world has settled down to a course of greener energy, crude oil is still in high demand. Oil is used in various sectors of the economy: powering up vehicles, heating buildings and producing numerous things from plastic items to fertilisers. 

Two major types of crude oil traded in the market are Brent and WTI. These types of oil are global benchmarks for the industry. 

Both Brent crude oil and WTI crude oil are light and sweet, meaning they have low density and low sulphur content. Such characteristics make them relatively easy to extract and refine. 

The prices for Brent crude oil and WTI crude oil have positive correlations with world economic growth throughout history — the economy’s growth results in increasing demand for oil which drives its prices up.

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However, in 2020, oil prices fell into the negative sector. Oil demand fell because of the travel restrictions and closing of businesses caused by the coronavirus pandemic. In the first quarter of 2020, oil consumption was 5.6% lower compared to the first quarter of 2019.

The price of oil impacts almost every good and service. For instance, oil prices affect prices for gasoline since 54% of the gasoline price is dependent on the price of crude.

Soybeans

Soybeans can be used to produce soybean oil, soy meat, biofuel, and other uses. According to the US Department of Agriculture (USDA), the US is the leading producer and exporter of soybeans delivered mainly to China, the EU, Japan, Mexico and Taiwan.

Soybeans are one of the most popular and actively traded agronomic commodities. Over the past 20 years, the global production of soybeans has doubled, and now its market capitalisation reached $123 billion. 

Soybean futures were traded at the lowest price between 1999 and 2002; however, the contract entered a strong uptrend later on.

As of July 2022, soybeans were traded at around $16 after a price spike in 2020.

The global soybean market has shown a steady rise for the past few years, and many traders have a positive vision of the soy market in the future. Thus, Transparency Market Research predicts that the value of the global soybean market will grow from $146.23 billion to $215.746 billion by 2025.

Gold

A precious metal is primarily mined in China, Australia, Russia and the US. It has been a desired asset for many centuries and is now mainly used for jewellery production, electronics, and as an investment asset.

Gold commodities are the most widespread. It is considered a safe-haven asset, meaning it can retain value or even rise in price during economic crises or political upheaval.

Although gold prices are relatively stable, many factors like inflation, deflation, supply and demand, and geopolitics can influence them.

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Gold is now the fifth-most-traded commodity contract. For the 20 years between 1980 and 2000, gold traded between $400 and $500, and the recent uptrend has pushed the price to over $1,830 in 2023. The experts forecast the increase in the gold price to $2,248 by the start of 2025.

Coffee

Coffee beans are grown in more than 50 countries, in what is known as the “coffee belt”. The largest coffee producer is Brazil. 

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The price of raw coffee is determined by supply and demand, defined by large coffee firms like Nestle and Kenco. The firms’ demand is based on the consumer demand for drinking coffee.

In recent years the demand for coffee has been growing since it has become a trendy drink which has led to an increase in the number of specialist coffee houses like Starbucks. Also, coffee is seen as an alternative to alcohol, resulting from the global healthy lifestyle trend.

However, the coffee supply depends on such factors as the number of firms and countries that produce coffee and the productivity of coffee growers.

The experts predict that, in the short term, the coffee price can fluctuate due to climate changes and the spread of various diseases. Coffee is a volatile commodity. Since the demand for coffee is not flexible enough, a slight shift in supply can result in a significant price change.

Natural Gas

Natural gas is another essential non-renewable source of energy for the entire world.

Natural gas is considered the cleanest burning fossil fuel and serves many of the same purposes as crude oil.

The consumption of both crude oil and gas will need to be decreased as the world attempts to reduce emissions to zero value by 2050. However, natural gas is anticipated to continue to be a significant global energy source during the transition period since it produces fewer emissions than oil.

Some experts predict the constant increase in gas prices will reach $22.47 by 2030.

Conclusion

Futures offer a quick and economical means of getting access to the financial and commodity markets. Trading commodities futures can be profitable, though it also entails high risks. There are thousands of commodities to consider for investment, like gold, coffee or natural gas. Nevertheless, no matter what commodity you choose, you must do some background research and learn commodity trading basics so that your investments are beneficial. 

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