Commodities Futures 101 - All you need to know

Of the many different types of market investments options in India, many traders trade in the commodities market. As is apparent from the term, this is a market in which different types of commodities such as agricultural commodities, metals, plastics, oils and energy sources and so on are traded. Investors enter into two main types of contracts while trading in commodities – options and futures. Here’s all you need to know about the latter kind of commodity trade i.e. commodity futures.

Commodities futures contract – definition

A futures contract is simply an agreement to purchase or sell a predetermined quantity of a specific commodity, at a predetermined price at a particular date in future. Details such as the delivery location and the quality of the commodity are also specified in the contract. Investors have two options – they may take the long position and be the buyer or the short position and be the seller. The long position is taken by investors expecting commodity futures prices to rise, whereas short positions are taken when prices are expected to fall. Such contracts allow commodity traders to avoid price fluctuation risks.

Commodities and price fluctuations

Commodity prices may change every day or every week. If you are a buyer in the commodity market, you can make a profit, when commodity futures prices rise. You can get the commodity at lower prices, as agreed-upon in the futures contract and make a profit by selling the commodity at the current, higher market price. However, if the price of the commodity falls, the seller stands to gain a profit. In such a scenario, the seller purchases the commodity at lower prices and it is sold to the futures buyer at high prices as mentioned in the futures contract.

Commodity futures contracts – the salient features

• Standard contracts: The most basic feature of this kind of contract is that it is highly standardised. The commodity futures contract features details of everything – the quantity of the commodity, its quality, delivery date, price and venue and so on. These details are determined by the exchange in which commodities are traded.
• Trading is done on organised exchanges: All commodity contracts are traded on exchanges authorised by the Government of India. Typically, contracts are traded on Multi Commodity Exchange of India (MCX) and National Commodity and Derivatives Exchange (NCDEX) in India.
• The contracts can eliminate all default risks: All members entering into commodity contracts are obligated to fulfil all the terms and conditions as mentioned in the futures contracts. Buyers and sellers are bound by these terms, which eliminate all risks associated with defaulting on the contract.
• Traders can utilise the margin trading facility: Commodity futures traders need not pay the entire contract value. They can simply deposit a margin of 5% to 10% of the actual value of the contract. Doing this allows investors to take larger positions, while reducing the burden of investing a high capital.
• The practices in the market are fair: The futures market is regulated by government agencies such as the Forward Markets Commission (FMC) in India. These agencies ensure that trade practices in the commodity markets are fair.

Just like futures, many investors also deal in option trading by selecting the most active options. Trading in commodity options is considered less risky as compared to future trading, but the profits earned are also considerably lower. However, if option trading interests you, you should research about the best option to trade in before you begin trading commodity options. You can easily find this information on business news websites; especially the live market websites providing regular day-trade updates.

Maithili Pawar is a finance professor. She has written on share market basics. Through this article, she has provided detailed information on stock market.