WHAT IS A COMMODITIES FUTURE?

In the US comedy Trading Places, actors Dan Aykroyd and Eddie Murphy made a substantial amount of money, at the expense of their former employer, by investing in futures on Frozen Concentrated Orange Juice. They did this by selling futures at a high price before buying 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. But 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.