Basics of Commodity Futures Markets

Futures markets have been described as continuous auction markets and as clearing houses for the latest information about supply and demand. They are the meeting places of buyers and sellers of an ever-expanding list of commodities that today includes agricultural products, metals, petroleum, financial instruments, foreign currencies and stock indexes. Trading  has also being imitated in  future contracts , enabling  option buyers to participate in future market with known risks. In other words Futures markets have been described as continuous auction market and as a clearing house for the latest information about supply and demand.

Participants in Future Market

The following are the participant in future market which are as follows:

  • Hedgers: Hedgers are individuals and firms that makes purchases and sales in the future market  solely for the purpose  of establishing  a known price level –weeks or month in advance  -for something  they later intended to buy and sell in the cash market in this way  they attempt to protect  themselves  against  the risk of unfavorable price change  in the interim .Hedgers may use  futures to lock  in an acceptable  margin between  their purchases price and their selling price
  • Speculators: Speculators are individuals and firms investors who accept the risk. In other words the speculator are individual and firms who seek to profit  from anticipated  increase or decrease  in future  price . Someone who expects  a future price  to increase  would purchase  futures contracts  in the hope  later  being able  to sell them  at a higher price ,this is known as “going long”, while on the other hand  someone who expects a future price decline would sell  futures contracts in hope  of later  being able  to buy  back identical  and offsetting  contacts at lower price , the practice of selling futures contracts in anticipation  of lower price  is known as “going short”. Most of the  speculative  investor have  no intention  of making  or taking delivery of  the commodity  but, rather  seek to profit from  a change in the price .
  • Floor traders: Floor traders are person who buy and sell for their  own accounts on the trading floors of the exchange and are the least known  and understood of all futures market participants ,Actually they have no guarantee they will realize a profit , they can loss of money on any trade, basically the floor trader make more liquid and competitive market

Futures Contracts

Futures contract involves obligations of both parties to perform in the future–the buyer (long) to purchase the asset underlying the future and the seller (short) to deliver the asset. Thus, both the buyer and the seller of a futures contract must initially post and maintain, on a daily basis, margin to assure contract performance and the integrity of the marketplace. In other words Futures contract is the agreement   between two parties to buy or sell an asset at a certain time in the future for a certain prices. It is normally traded in the exchange

Forward contracts are bilateral contracts to manage price risk and quantity risk to certain extent and would act as a boost for futures markets for the following reasons

Need of Futures Trading

Futures trading in commodities results in and fair price discovery on account of large-scale participations of entities associated with different value chains. It reflects views and expectations of a wider section of people related to a particular commodity. It also provides effective platform for price risk management for all segments of players ranging from producers, traders and processors to exporters/importers and end-users of a commodity. It also provides hedging, trading and arbitrage opportunities to market players.

Types of Futures Contract

There are two types of futures contracts which are as follows

  1. Physical delivery of commodity contracts: in this type of futures contract the physical delivery of the commodity is based on the desire of the buyer and seller both at the time of contract expired.
  2. Call for a cash settlement contracts: Cash settlement futures contracts are precisely that contracts which are settled in cash rather than by delivery at the time of the contract expired.

How To Choose The Future Contract

The market of for one commodity may be highly volatile at one time but not highly volatile at another time. The investor must consider following thing while choosing any future contract which are as follows:

  • Liquidity : A liquid market  will exist for offsetting  a futures  contract that investor have  previously  brought or sold , two useful indicator  of liquidity  are the volume  of trading and  the open interest
  • Timing: In future trading it is   necessary to anticipate the timing of the price change which may reflect the decision of the investor
  • Stop Orders : A stop order is an order , placed  with  broker  to buy or sell  a particular  future contract at the market price  if and  when  the price  reaches  a specified level  stop order  are often  used by  future  traders in an  effort  to limit  the amount they have
  • Spreads : Spread involves buying  one future contract  and  selling another  future  contract , the main purpose  is to  profit  from an expected  change  in the relation ship  between  the purchase  price of one  and the selling  price of the other. In other words the spread involves the purchases of one futures contract and the sale of a different future contract in hope of profiting from a widening or narrowing of the price difference.
  • Options on futures contracts: The Put and Call option are being traded on a growing number of future contracts. The main principal attraction of buying an option is that they make it possible to speculate to increase or decrease future price with a known and limited risk. In call option  buyers acquires the right  but not the obligation  to purchase  a particular  futures  contract at a specified price  at any  time  during  the life of the option. A Put option convey the right to sell  a particular  futures contract at specified price , put option  can be purchased to profit  from  an anticipated  price decrease.

The Process of Price  Discovery

The process of price discovery in futures contract is continuous. The price of future increases and decreases largely because of the myriad factors that influence buyers and the seller’s judgment about what a particular commodity will be worth at a given time in the future. With the arrival of new or more accurate information the price of the futures contract might increase or decreases in response to changing expectations

As a new supply and demand development occurs as new and more current information becomes available, these judgments s are reassessed and the price of a particular future contract may be bid upward and downward

After The Closing Bell

Closing bell signals  the end of a day’s trading , the exchange’s clearing organization  matches each  purchase made a day with the  corresponding  sales and tallies  each member  firm gain or losses  based on  that day’s price  change , a massive  undertaking considering  that near two-third of a million futures  contracts are bought and  on an average day. Gains and losses on futures contracts are calculated on daily basis and they are credited and debited on a daily basis.

Trading

An absolute requisite for any one considering trading in futures contracts that  to clearly understand  the concept  of leverage  as well as the  amount of  gain and loss that will result  from any given  change in the  futures price  of the  particular  futures contract in which you are liking to deal. If you cannot afford the risk, or even you are not comfortable with the risk then it is not suitable to trade in futures

Margins

Margins are basically the sum of money deposited by the investors towards his trader or broker on his/her good faith.

In futures  trading  the margin is required to buy  or sell  a futures contract is on solely  a deposit  of good faith money  that can be  drawn  on by brokerage firm to cover  loss that incurred by the investor in course of future trading. The minimum level of margins for a particular futures contract at a particular point of time is set by the exchange on which the trading take place. Exchange continuously monitor market condition and risk and as necessary, raise or reduce the margin requirements .Individual brokerage firm may charge or require higher margin amount from their customers than the exchange set minimum.

There are two types of margins

  • Initial Margin: Initial Margin is the sum of money that the customer must deposit with the brokerage firm for each future contract to brought or sold .If on any day that profit accrues on investor open position, the profit will be added in the balance of investors margin account
  • Maintenance Margin: Maintenance Margin is the additional amount which is required to deposit by investor on call by brokerage firm due to losses suffered in previous future contract to get the margin to the level of initial margin. when brokerage firm call for additional margin is called  margin call

In short and simple words Maintenance Margin is the minimum margin balance which must be maintained by investor with brokerage firm to reduce losses at a certain level .

Trading Strategies

There are various of the different strategies  and  variation of  strategies are used in future trading for  getting speculative profit in short time , some of the strategies are as follows :

  • Buying (Going Long)  to profit from an expected price increase
  • Selling (Going Short) to profit  from an expected price decreases
  • Spread

Buying (Going Long)  to profit from an expected price increase : In this view the investor expecting the  price of a  particular commodity or item  to increase  over from a given  period  of time  can seek to profit  by buying  futures contract. If forecasting is in correct direction and timing of the price change s, the future  contract  can  later be  sold for the higher  price , there by yielding  a profit, if on the other hand  price decline  rather than increase , the trade  will result  in a loss.

Selling (Going Short) to profit from an expected price decreases: In this strategy the investor sells the future contract if he/she expecting a decline in the price of the future so that a profit   can be realized by later purchasing an offsetting future contract at the lower price.

Spread : Spread involves buying  one future contract  and  selling another  future  contract , the main purpose  is to  profit  from an expected  change  in the relation ship  between  the purchase  price of one  and the selling  price of the other.

Method of Participating In Future Trading

The method of participating in future trading is based and depend on the  need and want of the investors in making trading decision as well as his/her  perceptions like from this we can categories the method of participating in future trading in four categories which are as follows :

  • Trade your own account
  • Have someone manage your account
  • Use a commodity trading adviser
  • Participation in a commodity pool

Trade your own account : Under this method  the investor has to open  his/her individual trading account , with or with out  the recommendation  of the brokerage firm , in which the investor take sole decision regarding  trading decisions , investor  will also responsible  for assuring  that adequate  fund s are on deposit with  the brokerage firm  for margin purposes and the such  funds  are promptly provided  as needed. An  individual  trading account  can be opened either  directly  with  a future  commission  Merchant  or indirectly  through an introducing broker. Future Commission Merchant are required to maintain the funds and property of their customer in segregated account (Separate from the firm’s own money). Introducing broker do not accept or handle investor funds but most offer a variety of trading-related services.

Have someone manage your account: A managed account is also an individual account. The major difference  is that  investor  give someone rise  to an account manager in which  written power of attorney is made in favors of account manger  to make  and execute  decisions about what  and when to trade . He or she  will have discretionary authority to buy or sell for investor account or will contract  investor  for approval  to make  traders he or she suggests in this case the  investor  remain fully  responsible  for any losses which  may incurred and as necessary ,for meeting margin calls , including  making  up any deficiencies  that exceed your margin  deposit.

Use a commodity trading advisor: A commodity trading advisor is  a  individual that  take  a fee and provide  advice  on commodity  trading, include all specific recommendation  such as when to establish  a particular  long  or short  position  and when to liquidate  that position , trading recommendation  may be communicated  by phone , wire mail.

Participation in a commodity pool : Another alternative  method of participating in the  future trading  is through future trading, it is only the method  of participation   in which investor will not have his own trading account  , in fact his money  will be combined  with  that  of other  pool participants b and in effects traders as a single account . Investor share in the profit or losses of the pool in proportion to his/her investment in the pool. One potential advantage is greater diversification of risks than investor might obtain if investor were to establish his own trading account. Another advantage is that  the investor risk of loss is generally limited  to his/her  investment in the  pool , because most pools are  formed  as limited partnerships  a pool  must execute all of its  trades through a brokerage firm which is registered  with  the CFTC as a Future commission Merchant , it may or may not have any other affiliation with brokerage firm  .Some  brokerage  firms, to serve  those  customers who prefer  to participate  in commodity  trading through a pool , either operate or have  a relationship with one or more commodity trading pools.

What are the Requisite in Future Contract

Future contract is wide contract contain various thing but the following are the some of the  requisite of future contract and must be considered by the investor before making any decision of investment in the future  which are as follows :

  • The Contract Unit: The Contract Unit specifies that how much quantity is contracted in the future contract to make settlement at the expiration of the future contract.
  • Quotation of price: Future price  are usually quoted  the same way price are  quoted  in the cash market while the cash settlement  contract prices are  quoted  in terms of an index number , usually  stated  to two decimal points
  • Minimum Price Change: Exchanges establish the minimum amount that the price fluctuates upward or downward. The process of establishing the minimum amount by exchange is known as “TICK”
  • Daily Price Limits :  Exchange establishes daily  price limits  for trading  in future  contracts , the limits are stated in terms  of  the previous  day’s closing price plus  and minus  so many cost per trading unit . Once a  future price  has increased  by its daily limit , there  can be  no trading  at any higher  price until the next day of trading , if on the other hand if the  futures prices has declined by its  daily limit  there can be no trading  at any lower price  until the next day of trading. The daily Price Limits set by the exchange is subject to change
  • Position Limit : Exchanges and the CFTC establish limits on the maximum speculative  position  that one person  have at one  time in any one future contract, the main purpose is to prevent  one buyer or seller  from being able to  exert undue influence on the price  in either  the establishment  or liquidation  of positions, Position limits are  stated  in the number of contracts or total  units of the commodity.

Source: Scribd.com

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