The Commodity Futures Market

As you learn the basics of investing, you’ll find some segments of the market harder than others. Those of you that have looked into Commodity Futures & Options know what I’m talking about. This is arguably one of the most complex and risky parts of the investment world. Still, more than 1 billion futures and options contracts are traded on the U.S. Futures Exchange.

Commodity Futures and Options are not the same as stocks, meaning they are not equity. They are basically contracts for future delivery, at a locked in price, of a wide range of products from soybean and pork bellies to oil and gas.

The futures contract, as we know it today, evolved as farmers and dealers began to commit to future exchanges of grain for cash. For instance, the farmer would agree with the dealer on a price to deliver to him 5,000 bushels of wheat at the end of June. The bargain suited both parties. The farmer knew how much he would be paid for his wheat, and the dealer knew his costs in advance.

Commodity Futures are traded on special markets with Chicago being the town of choice. The Chicago Board Options Exchange, The Chicago Board of Trade and The Chicago Mercantile Exchange (the largest) are a few.

A cash commodity must meet three basic conditions to be successfully traded in the futures market:

• It has to be standardized and, for agricultural and industrial commodities, must be in a basic, raw, unprocessed state. There are futures contracts on wheat, but not on flour, for example.

• Perishable commodities must have an adequate shelf life, because delivery on a futures contract is deferred.

• The cash commodity’s price must fluctuate enough to create uncertainty, which means both risk and potential profit.

There are two basic categories of futures participants: hedgers and speculators.

In general, hedgers use futures for protection against adverse future price movements in the underlying cash commodity. The rationale of hedging is based upon the demonstrated tendency of cash prices and futures values to move in tandem. Hedgers are very often businesses, or individuals, who at one point or another deal in the underlying cash commodity.

For speculators, futures have some advantages over other investments:

• If the trader’s judgment is good. he can make more money in the futures market faster because futures prices tend, on average, to change more quickly than real estate or stock prices, for example.

• Futures are highly leveraged investments. In general, futures are harder to trade on inside information.

• Commission charges on futures trades are small compared to other investments.

• Most commodity markets are very broad and liquid.

In most cases, delivery never takes place. Brokerage firms watch their open accounts and know who has positions in contracts nearing maturity. Prior to delivery day, they inform customers who have open positions that they must either close out the position or prepare to take delivery and pay the full value of the underlying contract.

You too can choose to trade in this market by yourself after you’ve cleared through a registered broker licensed for that particular market. But, before you decided how you want to play you have to ask yourself… How much do I want to be involved in trading on this market and do I have the time to commit to that? There is the trading, research, tracking, administrative task, regulations and rules, keeping abreast of fraud alerts and following the glossary. This market has a vocabulary all its own. Be cautious and don’t assume because you know the stock market or the Fixed Income Market, the Futures Market will just fall in line.

A good resource is The National Futures Association. You can call them at 1-800-676-4632 to get all the basic information on the market and find out, if you plan to hire a broker, if any disciplinary action has been taken against him/her.