Basics of Commodity Futures

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Commodities are an important part of everyday life. Commodities have become an attractive investment vehicle.  In other words commodity is raw material or primary agricultural product that can be bought and sold. Such as copper or coffee. Commodities are divided into five sectors. Like Agriculture, metals, precious metals, energy and services.

What are Commodity futures?

Commodity futures are agreement to buy or sell raw material at specific date in future at price agreed. It is an agreement to buy or sell commodity at certain time in future at certain price. There are three main areas of commodities are food, energy and metals.

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Commodity futures contract is tool for retail investor and trader to participate. And trading in commodity futures contracts are very risky for inexperienced because most investors lose money in commodities futures. This happens only when you do not trade with discipline and fear.

How it works

If price of underlying commodity goes up then buyer of futures contract makes money and you gets product at low agreed price also you can sell it at today’s high market price.  However, if price goes down futures seller makes money and you buy commodity at today’s lower market price also sell it to high agreed price.

They will fulfill contract by delivering proof that product is in warehouse. And they also pay cash difference or by providing another contract at market price. In case of stock future you do not have to pay entire amount just fixed percentage of cost of commodity which is known as margin. This initial margin can be paid to take a position or trade in commodity futures market.

Let’s say you are buying Gold Futures contract of 100 g worth of Rs. 2,80,000/-. Margin for gold set by Exchange is 4 to 5%. So you only end up paying Rs. 14,000/-. And low margin means that you can buy futures instead of large amount of gold by paying only a fraction of price. So you bought Gold Futures contract when it was Rs 28000 per 10 Gms.

Then next day, gold price rose to Rs 28500 per 10 Gms. Then Rs.500 (Rs 28500 – Rs 28000) will be credited to your account. But following day, if price dips to Rs 27500 then Rs 500 will get debited from your account (Rs28000 – Rs 27500). This profit or loss is called Mark to Market. In this way trade happens.

Benefits of investing in commodity futures

Primary objectives of any future exchange are price and risk management. And those who trade in commodities offered in exchange as well as those who have nothing to do with future trading. It is because of price discovery and risk management through existence of futures exchange to function smoothly. There are certain advantages those futures trading offers to interested investors below.

High Leverage

As commodities future trading is done on margins and is less than equity markets. And it gives you greater leverage and ability to make higher returns. That is how leverage works to give advantage in futures trading.

In order to own futures contract you only needs to invest small fraction of value of contract. Most investors invest ten percent of contract’s value in exchange for trading. This way, you may trade larger amounts of commodities than if you bought commodities outright.

Less Manipulation

Another advantage of futures trading is that futures contract is very liquid. This means that there are huge amount of contract being traded in market on daily basis.  Such gold and silver are global commodities and their prices are high in the market. There are fewer manipulations. Also see Indian Commodity market Introduction (Not Posted)

Diversification

There is diversification as per returns from commodities market and are not directly connected to price fluctuations in equity or debt market. Another advantage commodities offer is diversification. Diversification is when you invest in many industries that react different changes in market. This keeps your annual return steady and avoids big losses.

For example, investing in both oil and car companies protect you against losses from rising oil prices. In this case, oil companies will go up in value while car companies will go down. Commodity investments tend to move in opposite direction as regular stocks and bonds. They give advantage to your portfolio.

Hedge Inflation

Inflation is bad news for regular investments. As dollar value goes down, American stocks and bonds earn less and fall in value around the world. Therefore, commodity prices go up during periods of high inflation. These prices also go up due to other investors sell off their stocks and bonds to buy up commodity investments. By holding some commodities in your portfolio you will be able to take advantage of this upswing.

Liquidity

Investments in commodity futures offer high liquidity and It is easy to both buy and sell futures. So you can easily liquidate your position whenever required. There is also another advantage to use profits from trade without having to close position.

Commodity Futures Markets features

Price discovery and price risk management are main objectives of futures exchange. The benefits of commodity futures market are as follows below. For more information see five things to do for festive season (http://www.financialwing.com/five-things-festive-season)

  • Price Discovery
  • Price Risk Management
  • Import and Export competitive
  • expected Pricing
  • Control over bad price fluctuations for farmers
  • Credit convenience
  • Better product quality

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