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.

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