A Trader’s First Lesson On Commodities

In this buzz is your first lesson on commodities. Future contracts, conventional letter codes, hedgers and speculators. All in one article. (< 5 min. read)

Futures markets  first appeared in the US in the mid-1800s, at the Chicago Board of Trade (CBOT). Futures contracts and futures trading as we know them today have undergone many changes and improvements, and will probably continue to evolve as global trading and investment needs change. However, the principles on which they are based remain the same. 

1. Futures contracts

Futures contracts are an important risk transfer mechanism, which makes them extremely valuable in an environment of uncertainty and high volatility.

Simply stated, a futures contract is a legally binding agreement to buy or sell a commodity or financial instrument at a later date. The contract is standardized according to quality, quantity, delivery date and location, but not price. Price is determined by the market forces of supply and demand, making futures contracts an ideal instrument for all market participants. 

Futures contracts are based on a huge variety of different underlying products, such as agricultural commodities, securities, precious metals, crude oil, natural gas, foreign currencies, interest rates, and stock  indexes. 

Basically, there are two types of futures contracts, those that provide physical delivery of the underlying and those which require a cash settlement. The month that the delivery or the settlement is to occur is specified in the contract and is known as the delivery date. 

Delivery date is the month in which the seller must deliver and the buyer must accept and pay for the commodity. For example, a July futures contract is one providing for delivery or settlement in July.

2. Conventional letters codes

Conventional letters codes specify the delivery month: 

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

The month code follows the contract code, which is then followed by the year. 

Take, for example: CLZ10—CL = crude oil, Z = December and 10 is for 2010.

In reality, few of the delivery-type futures contracts result in actual delivery. The vast majority of futures traders choose to offset their positions prior to the delivery date.

3. Futures Market Participants

Like any other market, futures markets are made up of buyers and sellers.  If you are a buyer, you will seek a seller at the lowest available price. If you are a seller, you will seek a buyer at the highest available price. Market fluctuation is a process of finding fair prices for both buyers and sellers. In either case, the person who takes the opposite side of your trade may be or may represent someone who is either a hedger or a speculator. 

A hedger is an individual or a firm that uses futures to minimize risk. Hedgers want to secure the price of something that they intend to buy or sell in the future. A hedge is a position established in the futures market in an attempt to offset exposure to price fluctuations in some opposite position in the cash market, with the goal of minimizing the unwanted risk. In short, the futures hedge locks in a set price for a commodity, regardless of what happens in the cash market.

Example: A jeweler will need to buy gold jewelry every six months to keep his inventory current.  The jeweler wants to keep his prices locked in at the same level as when he published his catalog. However, he fears the price of gold may increase, causing him to have to pay more for his stock.  So, he decides to purchase gold futures contracts for $1000 an ounce. If in six months, the price of gold rises, he will have to pay his supplier the new price, but the extra cost may be offset by the corresponding profit he would receive when he sells his gold futures contracts.  

A speculator is an individual or a firm that takes large risks, especially with respect to anticipating future price movements, in the hope of making rapid, frequent gains. Speculators accept the price risk that hedgers seek to avoid. Someone who expects that the price will increase in the future will purchase a futures contract now, hoping he will be able to sell it later at a higher price. This practice of purchasing futures contracts in anticipation of higher prices is called “going long”. 

On the other hand, if an individual expects that the futures price will decrease in future, he will sell a futures contract, hoping that he will be able to purchase it later at a lower price. This practice is called “going short.” 

Speculators have no interest in delivering or taking delivery of futures contracts, they merely seek to profit from price fluctuation.

“Commodities tend to zig when the equity market zag”

-Jim Rogers

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