WHAT IS A COMMODITIES FUTURE?

Have you ever seen the movie, Trading Places starring Dan Aykroyd and Eddie Murphy?

This movie gave many people their first look into the exciting and potentially profitable world of futures investing. Do you remember the end of the movie when Aykroyd and Murphy made a substantial amount of money, at the expense of their former employer, by investing in futures on Frozen Concentrated Orange Juice? They sold futures at a high price and were able to buy them back at a much lower price following the release of the crop report. The result: a life of luxury for the rest of their days. Out of interest this trade also makes clear an exciting technique with futures trading: you can sell a futures contract even though you didn’t previously buy it. That is, you can sell first and then buy back later, hopefully at a lower price.

Of course, futures trading in reality is not so easy, and it can carry quite a bit of risk, too. As with any investment, the first step to success is education. Perhaps the greatest appeal of futures trading is the high leverage. This means that to buy or sell a futures having a contract value of say, $100,000, and the trader need only deposit a small portion of this value in a trading account, maybe $3,000 or so depending upon the commodity. If the futures increases in price by 1%, then this results in $1,000 gain to the trader who is long the contract, and a $1,000 loss to the trader who is short the contract (not including commission and other transaction fees). Leverage is what makes futures trading risky.

A commodity futures contract is a firm commitment to deliver or receive a specific quantity and quality of a commodity during a designated month at a price determined by open auction on a futures exchange.

You can buy a futures contract on gold, lumber, pork bellies, and many other items. The underlying item or commodity is described specifically in the contract specifications which are determined by the futures exchange on which it trades. The price of a futures transaction is agreed upon initially between the buyer and seller, and remains fixed over the holding period, or length of the contract. The small amount of money that you need to deposit for buyers and sellers of a futures contract is called margin.

Finally, the full price of the commodity must be paid only upon contract expiration at which point you take delivery if you bought futures, or make delivery if you sold futures of the underlying commodity. Don’t worry. You don’t have to make or take delivery if you don’t want to. You can instead offset or square your position prior to the contract’s expiration.

When you buy a futures contract, the price represents the amount at which you are committed to buying the underlying commodity when the futures contract expires. Similarly, when you sell a futures contract, the price represents the price at which you are committed to sell the underlying commodity when the futures contract expires. (Not all futures contracts require physical delivery upon expiration; some are simply settled by cash.) For example, if you buy a COMEX December gold future at $380 per ounce, then you have the obligation to buy 100 ounces of gold at a price of $380 per ounce in December when the future expires. The price of a gold future constantly fluctuates in response to several factors such as supply and demand, interest rates, and prices of other precious metals. However, no matter what the price of gold does after you buy the future, you will be able to buy gold at the price of $380 per ounce – you have locked in this purchase price.

When you buy futures, you lock in a purchase price for the underlying commodity. Similarly, when you sell futures, you lock in a selling price of the underlying commodity. If prices go up after you buy a futures contract, then you will earn a profit since the futures contract has increased in value. For example, if you buy one gold futures contract at $340 per ounce and two weeks later, the same gold futures contract is trading at $350 per ounce, then your futures contract is now worth $10 per ounce more than when you bought it. One futures contract represents 100 ounces of gold, so the total profit on your gold futures position is $1,000. Obviously the reverse could have happened and gold futures prices could have fallen instead, in which case you would have suffered a loss.