Futures trading denotes an investment that speculates the price of a commodity increasing or decreasing in the future. In essence, futures trading involves capitalizing on the fluctuations of commodity prices, i.e. profit from buying a commodity at a low price and selling it at a higher rate. Commodity markets trade in the primary economic sector instead of manufactured goods.
Commodities are loose categorized as soft or hard commodities.
These are basically agricultural produce such as:
- Cocoa etc.
Hard commodities are those that have been mined. It includes:
- Minerals etc.
What are Futures Contracts?
Futures contracts are derivatives in nature, as their value is derived from an underlying asset. These contracts can be freely traded between persons or institutions, who buy a commodity at today’s rate and get it delivered at a future date as specified in the contract. This helps investors to post profits if the market price of the traded commodity increases by the delivery date.
The futures contracts have expiration dates, however there is no compulsion to hold the contracts till expiration. You can choose to cancel them at any point during the tenure – a minute, hours or months.
Futures contracts have 2 different positions namely short (sell) position which obligates delivery at specified date and long (buy) position which obligates acceptance of delivery at specified date. Investors may tend to initiate a short position while holding a long position on the same contract, thereby removing the original long position.
Contracts can be purchased for the specified expiration dates. For instance, if you are trading gold futures you may see contracts for February, April, June, August, October and December. If you feel that gold prices will pick up in September or October, you can purchase a contract for delivery in October, which will allow you to hedge against inflation for the specified tenure while also enabling you to make profits.
Types of traders
There are 2 major types of investors in futures contracts – speculator and hedgers. Speculators account for almost 97% of the total futures trading.
Hedger: Hedgers are producers of commodities such as mining company or a farmer. These entities trade in futures contracts to shield themselves from price volatility in the future. For instance, a cocoa farmer may feel that the prices of the commodity may fall by the harvest time. To hedge against perceived losses, he can sell a futures contract at the present rates, and then exit the trade by buying cocoa at lower prices during the harvest time. In essence, he sold the cocoa first at higher rates, and then when the product was actually harvested, he purchased it at lower rates, profiting from the difference between selling and buying prices. Pension fund companies, insurance companies and banks are some of the other hedgers.
Speculator: This group includes private investors and independent floor traders. These entities concentrate on making profits by buying a contract that is expected to rise in future and selling a contract expected to fall in future. This type of investors trade futures contracts similar to shares and stocks by purchasing at lower rates and selling when prices climb.
Benefits of futures contracts
Prospectively higher returns
Futures denote highly leveraged investments. To actually buy a futures contract, you need to pay only a fraction of the actual value of the contract, say 10%. This 10% is termed as margin and is more like a security deposit to ensure cover for losses in case your contract doesn’t perform as you expected.
Now, let’s say you have $6,000 to invest (gold futures are traded in Dollars). With this amount you can either:
- Buy 20 ounces of physical gold ($300/ounce),
- Buy 200 shares in a mining institution ($30 per share)
- Buy 4 futures contracts. (One contract typically holds 100 ounces of gold. You will have enough to cover the margin for 4 contracts and consequently speculate with ($300*100 ounces*4) $120,000 worth of gold.
Now, assuming gold prices appreciated by 20%, the first and second options above will give you returns of around $7,200 for $6,000 worth of investment. That’s a profit of $1,200.
Now, consider the third option. Your futures contracts are now valued at $144,000 – a profit of $24,000.
Comparing both the option, your returns are almost 20-fold. However, a point to note here is that if the commodity prices go down, you stand to lose the security deposit of 10% and may have to pay excess amounts if the losses are higher than 10%.
No need to hold physical gold
Futures contracts are mostly used as speculative instruments that are basically carried out on paper. You don’t actually hold a tonne of gold or 5,000 barrels of oil in your house – you simply have a paper confirming that you hold a specified quantity of the commodity. Exchange of commodity happens in the rare times of delivery of contracts.
A fairer market
Getting ‘insider information’ is very difficult in commodities trading. Also, market reports are provided toward the end of trading sessions, enabling you to make more informed decisions for the next day.
There are huge numbers of contracts traded daily on futures. This makes it possible to place orders quickly as there are lots of buyers and sellers actively trading a commodity. Prices also tend to post gradual appreciation or depreciation instead of large jumps, especially so for nearer contracts of next few weeks or months.
The commission charges are generally lower compared with other investments and applied depending upon the type of service offered.
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