how a commodity futures contract works
most commodity futures contracts are closed out or netted at their expiration date the price difference between the original trade and the closing trade is cash settled commodity futures are typically used to take a position in an underlying asset typical assets include commodity futures contracts are called by the name of their expiration month meaning a contract ending in september is a september futures contract some commodities can have a significant amount of price volatility or price fluctuations as a result there s the potential for large gains but large losses as well commodity futures and commodity forward contracts are functionally similar the major difference is that futures are traded on regulated exchanges and have standardized contract terms forwards instead trade over the counter otc and have customizable terms speculating with commodity futures contractscommodities futures contracts can be used by speculators to make directional price bets on the underlying asset s price positions can be taken in either direction meaning investors can go long or buy as well as go short or sell the commodity commodity futures use a high degree of leverage so that the investor doesn t need to put up the total amount of the contract instead a fraction of the total trade amount must be placed with the broker handling the account the amount of leverage needed can vary given the commodity and the broker as an example let s say an initial margin amount of 3 700 allows an investor to enter into a futures contract for 1 000 barrels of oil valued at 45 000 with oil priced at 45 per barrel if the price of oil is trading at 60 at the contract s expiry the investor has a 15 gain or a 15 000 profit the trades would settle through the investor s brokerage account crediting the net difference of the two contracts most futures contracts will be cash settled but some contracts will settle with the delivery of the underlying asset to a centralized processing warehouse considering the significant amount of leverage with futures trading a small move in the price of a commodity could result in large gains or losses compared to the initial margin speculating on futures is an advanced trading strategy and not fit for the risk tolerance of most investors unlike options futures are the obligation of the purchase or sale of the underlying asset as a result failure to close an existing position could result in an inexperienced investor taking delivery of a large number of unwanted commodities trading in commodity futures contracts can be very risky for the inexperienced the high degree of leverage used with commodity futures can amplify gains as well as losses if a futures contract position is losing money the broker can initiate a margin call which is a demand for additional funds to shore up the account the broker will usually have to approve an account to trade on margins before it can enter into contracts hedging with commodity futures contractsanother reason to enter the futures market is to hedge the price of a commodity businesses use futures to lock in prices of the commodities they sell or use in production the goal of hedging is to prevent losses from potentially unfavorable price changes rather than to speculate many companies that hedge use or produce the underlying asset of a futures contract examples include farmers oil producers livestock breeders and manufacturers for example a plastics producer could use commodity futures to lock in a price for buying natural gas by products needed for production at a date in the future the price of natural gas like all petroleum products can fluctuate considerably leaving an unhedged plastics producer at risk of cost increases in the future if a company locks in the price and the price increases the manufacturer would have a profit on the commodity hedge the profit from the contract would offset the increased cost of purchasing the product alternatively the company could take delivery of the product at a cheaper fixed price hedging a commodity can lead to a company missing out on favorable price moves since the contract is locked in at a fixed rate regardless of where the commodity s price trades afterward also if the company miscalculates its needs for the commodity and over hedges it could lead to having to unwind the futures contract for a loss when selling it back to the market leveraged margin accounts only require a fraction of the total contract amount deposited initially speculators and companies can trade both sides of the market companies can hedge the price of necessary commodities and control costs the high degree of leverage can amplify losses and lead to margin calls and significant losses hedging a commodity can lead to a company missing out on favorable price moves since the contract is fixed if a company over hedges a commodity it can lead to losses from unwinding the contract example of commodity futuresbusiness owners can use commodity futures contracts to fix the selling prices of their products weeks months or years in advance for example let s say a farmer expects to produce 1 000 000 bushels of soybeans in the next 12 months typically soybean futures contracts include the quantity of 5 000 bushels the farmer s break even point on a bushel of soybeans is 10 per bushel meaning 10 is the minimum price needed to cover the costs of producing the soybeans the farmer sees that a one year futures contract for soybeans is currently priced at 15 per bushel the farmer decides to lock in the 15 selling price per bushel by selling enough one year soybean contracts to cover the harvest the farmer needs 200 futures contracts 1 000 000 bushels needed 5 000 bushels per contract 200 contracts one year later regardless of price the farmer delivers the 1 000 000 bushels and receives the locked in price of 15 x 200 contracts x 5000 bushels or 15 000 000 in total income unless soybeans were priced at 15 per bushel in the market on the expiration date the farmer had either gotten paid more than the prevailing market price or missed out on higher prices if soybeans were priced at 13 per bushel at expiry the farmer s 15 hedge would be 2 per bushel higher than the market price for a gain of 2 000 000 on the other hand if soybeans were trading at 17 per bushel at expiry the 15 selling price from the contract means the farmer would have missed out on an additional 2 per bushel profit 