Commodity Markets and Futures Trading

The process of trading commodities is also known as futures trading. Futures Contracting is an important activity for any economy to meet raw material requirements, to facilitate storage as a profitable economic activity and also to manage supply and demand risk, forward contracts gives rise to price risk, so to the need of price risk management, unlike other kinds of investments, such as stocks and bonds, when investor trade futures, he/she do not actually buy anything or own anything. He/she are speculating on the future direction of the price in the commodity in which they are trading. This is like a bet on future price direction. The terms “buy” and “sell” merely indicate the direction you expect future prices will take.

In other word Forward/Future trading is an activity in which a trader takes a position in an equity in advance of an action which he/she knows his/her brokerage will take that will move the equity’s price in a predictable fashion also called front running. Future / forward trading involves a passage of time between entering into a contract and its performance making thereby the contracts susceptible to risks, uncertainties, etc

Many people have become very rich in the commodity markets. It is one of a few investment areas where an individual with limited capital can make extraordinary profits in a relatively short period of time, nevertheless most of the people lose money, commodity trading has a bad reputation as being too risky for the average individual. The truth is that commodity trading is only as risky as you want to make it.

Functions of Futures Trading

Basically Futures trading perform two important functions;

  1. Price discovery: Describing the possible price of future contract in the future.
  2. Price risk management: Price risk management related with reference to the given commodity by buying and selling futures contracts that establish a price level now for items to be delivered later.

Characteristic of Future Trading

A “Futures Contract” is a highly standardized contract with certain distinct features. Some of the important features are as under :

  • Futures’ trading is necessarily organized under the auspices of a market association so that such trading is confined to or conducted through members of the association in accordance with the procedure laid down in the Rules & Bye-laws of the association.
  • It is invariably entered into for a standard variety known as the “basis variety” with permission to deliver other identified varieties known as “tenderable varieties”.
  • The units of price quotation and trading are fixed in these contracts, parties to the contracts not being capable of altering these units.
  • The delivery periods are specified.
  • The seller in a futures market has the choice to decide whether to deliver goods against outstanding sale contracts. In case he decides to deliver goods, he can do so not only at the location of the Association through which trading is organized but also at a number of other pre-specified delivery centers.

In futures market actual delivery of goods takes place only in a very few cases. Transactions are mostly squared up before the due date of the contract and contracts are settled by payment of differences without any physical delivery of goods taking place.

Benefits of Future trading

Futures’ trading is useful and beneficial to all segments of the economy like

  • To Producer: Futures trading is useful to the producer because he can get the idea of the price likely to prevail at a future point of the time and therefore can decide between various competing commodities , the best that suit him.
  • To Consumer: Futures’ trading is useful to the consumer because he/she get an idea of the price at which the commodity would be available at a future point of the time.
  • To Exporters: Futures trading is useful to the exporter because it provide an advance indication of the price likely to prevail and thereby help the exporter in quoting a realistic price and there by secure export contract in a competitive market , Futures trading enable exporter to hedge his/her risk by operating in future market.

Other benefits

The other benefits which are served by futures trading are:

  • Price stabilization-in times of violent price fluctuations – this mechanism dampens the peaks and lifts up the valleys i.e. the amplitude of price variation is reduced.
  • Leads to integrated price structure throughout the country.
  • Facilitates lengthy and complex, production and manufacturing activities.
  • Helps balance in supply and demand position throughout the year.
  • Encourages competition and acts as a price barometer to farmers and other trade functionaries.

Futures’ trading is also capable of being misused by unscrupulous speculators. In order to safeguard against uncontrolled speculation certain regulatory measures are introduced from time to time. They are:

  • Limit on open position of an individual operator to prevent over trading;
  • Limit on price fluctuation (daily/weekly) to prevent abrupt upswing or downswing in prices;
  • Special margin deposits to be collected on outstanding purchases or sales to curb excessive speculative activity through financial restraints;
  • Minimum/maximum prices to be prescribed to prevent future prices from falling below the levels that are un remunerative and from rising above the levels not warranted by genuine supply and demand factors.

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