The formal regulation of futures trading in the United States and the UK towards the end of the 20th century resulted in a robust expansion of the futures market globally. Although futures contracts were primarily used as a means of trading commodities on paper, today, the market has incorporated other assets, including cryptocurrencies. Trading futures contracts is open to both institutional investors and individual retail traders. But what exactly are futures contracts for commodities, and how can you trade these unique financial instruments? This article discusses the basics of futures and how to trade futures contracts for commodities.
What is a Futures Contract?
This is an agreement between two parties to purchase or sell a commodity asset at a specified time in the future, and for a predetermined price. Basically, the contract places the buyer at an obligation to purchase and receive a commodity asset upon the expiration of the contract. On the other hand, the seller will be obliged to deliver the underlying commodity asset when the contract expires. However, futures rarely result in the delivery of the commodity asset under contract. Instead, a majority of futures are entirely speculative. This means that a futures contract trade is closed by paying out the differences in the prices of the underlying commodity assets.
How Futures Work
Futures investors are not interested in receiving bulk amounts of the underlying commodity asset. Their key interest is in earning profits or yields from the volatility of commodity prices. Trading futures for profits is possible only if the traders close out their positions before the expiration date. Examples of commodity assets traded using futures contracts include oil, wheat, meat, livestock, stock index, grains, and metals. A futures contract will feature standardised quantities, qualities, and prices of a specified commodity asset, which is used to facilitate trade in a futures exchange. A futures exchange, in this case, is a centralised marketplace where futures are traded.
Usually, a futures trade takes place between two parties, including hedgers and speculators. Hedgers are the consumers and producers of a given commodity. Speculators, on the other hand, are traders who buy futures contracts for profit. For example, in the context of oil as the underlying commodity, an oil producer and such consumers as manufacturing and airline companies are the hedgers in a futures contract. An oil producer may want to lock in the price at which they will sell oil in the future, which can be achieved through a futures contract. Also, since companies plan ahead as far as procuring commodities is concerned, a manufacturing or airline company will need a futures contract to identify the price at which they purchase oil in the future.
Benefits of Trading Futures Contracts for Commodities
The benefits to trading futures are many, including the following;
High Liquidity – Generally, futures contracts are highly liquid. Traders can create as many contracts as they can within a day, and investors also cash-in futures at a significant rate. It is, therefore, very easy to buy and see a contract through, considering the high volumes of exchanges taking place daily.
The Possibility of Short Selling – The futures market allows traders to short sell contracts as they wish. If you can speculate a downward movement in the price of a specified commodity asset, then futures trading will suit you well.
Low Commissions and Fees – Although you will be charged some fees and commissions to trade futures, these costs are considerably lower than what you incur trading bonds and stocks.
Diversification – If you are looking for another asset type to diversify your investment portfolio, then you might want to consider trading futures. The structure, volatility, and risks of trading futures are entirely different from assets, such as mutual funds, stocks, and bonds. In case of a fall in the stock market, investors can use futures to shield their investment and minimise the amounts of losses caused by the downfall.
How to Trade Futures Contracts for Commodities
Speculators or traders of futures contracts participate in the futures market through a brokerage account issued by a licensed broker. In this section, you will find a step by step guide, highlighting a detailed breakdown of the futures trading process.
Step 1: Opening a Trading Account
The initial step to your trading experience begins with opening a trading account with a futures broker. You will also need to sign up for a margin account for you trade on margin, as well as shorting futures. To identify the best futures broker, you might want to consider the following factors;
Trading Platforms – A good broker should have various trading platforms that allow you to trade futures, including a mobile application. These platforms should also provide efficient customer service, analytical tools, research, and educational tools.
Charges and Commissions – Usually, a broker will charge you fees and commissions for various trading aspects. When choosing your broker, you will need to evaluate its fee and pricing schemes to ensure that you settle on the company with low charges.
Regulation – One of the most important factors to consider when choosing a futures broker is the legal status as a brokerage firm. This means evaluating whether a broker is registered with a futures exchange, as well as whether the company is authorised to offer brokerage services.
Margin Requirements – The futures market allows the use of a margin of up to 13% of the total value of futures contract. The margin requirements may, however, vary from one broker to another depending on various factors. Such factors include the underlying commodity asset and your country of residence. Scrutinise these requirements before selecting a broker.
Step 2: Decide on Your Investment Strategy
There are several strategies that you can employ to hedge, diversify, or speculate futures. These strategies include shorting, going long, bear calendar spread, and bull calendar spread strategies. When choosing a trading strategy, be sure to be conversant with its basics.
Step 3: Select Your Futures Contract and Timeframe
At this point, you will need to choose the month and year around which your contract should expire. The contract expires on the third Friday of your selected month, which determines whether you have made a profit or loss. Depending on the broker you choose, you will have a wide range of futures contracts to choose from, including currencies, metals, oil, meat, and metals.
Step 4: Place Your Order
This is where you place an obligation to buy a commodity asset for which you will speculate price movements.
Step 5: Manage and Monitor Your Trade
Once you initiate a futures trade, you will be receiving futures statements on a daily and monthly basis. These statements reflect the fees, money movements, and performance of your futures contract. You will be required to close out your position by liquidating it or rolling it forward before your contract expires. If you hold the contract to expiration, then the agreement will go to settlement. The settlement is executed by either receiving the commodity physically or paying cash.
Websites Where Futures Trading Accounts Can Be Created
Choosing a futures trading broker can be quite overwhelming, especially if you are a beginner in the market. Here is a list of some of the leading brokerage websites through which futures can be traded.
E-Trade is regarded as an all-in-one brokerage platform, providing investors with a wide range of futures. The platform providers traders with every essential tool for futures trading, including education, research, charting, and screening tools. E-Trade avails trading platforms in mobile application and desktop formats. To trade futures on margin using E-Trade, you will need a minimum deposit of $2,000. Traders on E-Trade have access to up to 60 futures contracts. This platform, however, has slightly higher commission charges of $1.50 per contract, which is payable at both sides of the transaction.
TD Ameritrade is a global leader in offering trading brokerage services. The site features over 70 types of futures contracts at competitive marginal requirements of 2% to 12%. Examples of commodity assets traded in these contracts include energy, currencies, stock indexes, metals, and forests. TD Ameritrade is also known for having advanced features and tools that enhance futures trading, including indicators and charting tools. For every futures contract, the platform charges a rate of $2.25, which is inclusive of exchange and regulatory fees.
NinjaTrader is another futures trading platform that is best suited for experienced traders. The platform features over 200 futures contracts, which comprise of commodity assets, such as gold, silver, agriculture, and stock indexes. The pricing in NinjaTrader comes at a discounted rate, where commissions are categorised into three tiers. These tiers include Lifetime, Lease, and Free pricing plans. NinjaTrader investors also get access to trade simulation, market analytics, and charting tools for free.
If you are looking for a professional trading platform for futures contracts, then Interactive Brokers is an ideal choice. This site is popular amongst institutional investors, such as hedge funds, providing them with the lowest margin rates in the market. To activate a margin account with Interactive Brokers, traders are required to make a minimum deposit of $100,000.
This platform is run by one of the global leaders in trading brokerage. Charles Schwab is designed with features and tools tailored to meet the trading needs of both beginners and experienced traders. The site has two primary trading platforms, including the StreetSmart Central and StreetSmart Edge, which enhance your futures trading experience.
Pitfalls Associated with Futures Trading
Trading futures contracts is generally risky. Traders must be conversant with futures and possess some trading skills to mitigate risks associated with futures contracts. Some of these risks include;
Liquidity Risk – This is the risk that it might be challenging to exit or close a position in illiquid contracts. Although futures are highly liquid, there may sometimes lack an equal opposite interest in the marketplace to have a trade initiated, posing the liquidity risk.
Interest Rate Risk – This is the risk that changes in the interest rates may impact the value of commodity assets held in a futures contract. For example, an increase in interest rates triggers a drop in the value of commodities.
Leverage Risk – One of the primary reasons why futures contracts are attractive amongst investors is the market’s provision of the leverage feature. However, this same feature subjects the futures market to what is known as the leverage risk. This is the risk that a trader may incur substantial losses when the market trends go against your speculation as placed in a margin or leverage trade.
Margin Calls – All executed futures trades must be closed out at a given time. Holding a contract to its expiration places into settlement, which are recovered through a margin call by your broker. Failure to respond to these margin calls may force the broker to close out your position, which includes liquidating your position. This is likely to cost you the initial capital that you used to open a position.
Metrics to Use When Trading Futures Contracts
When making decisions on your futures trade, it is essential that you undertake fundamental analysis on various futures contracts to measure their potential performance. The following metrics can be used to measure the performance of futures when speculating the movement of commodity prices.
This metric represents the total number of futures positions that are open and not yet closed. This is a good way to determine the attitude of investors towards a specified futures contract. Traders can also establish contracts with the most active trades. An increase in open interest shows the futures market is headed to a season of more active trading, as traders are opening new positions daily. This metric is published daily by major futures exchanges.
This is the most common metric used by futures traders. Volume is a measure of the total futures trades that take place in a specified marketplace at a given time. A high volume reflects a more liquid market. This also signifies that there are more active trades in a market. The vice versa is also true.
Futures Turnover Ratio
Looking at the open interest and volume metrics separately can be quite confusing sometimes. The turnover ratio accounts for both the volume and open interest of futures contracts to determine the speculative activity and level of hedging in the futures market. This measure is often taken relative to the existing open positions in the market. The futures turnover ratio is calculated by dividing volume by open interest of the total futures contracts. A high turnover ratio shows an increase in the number of contracts changing hands before they get into a settlement. A low turnover ratio, on the other hand, indicates a decline in the trading activity of futures contracts, which is a sign of declining speculation.
Contango and Backwardation
These two metrics are used to establish the difference in the spot price and future price of a contract. The spot price shows the current market value at which a commodity asset is traded for immediate delivery. On the other hand, the future price is the value of a commodity that is locked in for a future transaction.
Although futures markets are not as established as other financial markets, trading futures contracts generates higher yields than most securities. Futures contracts are very liquid, which makes the market more attractive to traders. Investors can use futures to hedge or shield their investment portfolios in case of a downfall in other assets, such as bonds and stocks. With the right trading tools and sufficient research on futures, traders can obtain high returns on their investment.