Commodity 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, a 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 price.
It is normally traded in the exchange. Forward contracts are bilateral contracts to manage price risk and quantity risk to a certain extent and would act as a boost for futures markets.
The agreement will commit the buyer and the seller to a fixed price that will be in effect on a specified future date.
When this future date arrives, the buyer is expected to have paid the agreed-upon price for the futures, and the seller will have delivered ownership of the commodities to the buyer.
Commodity futures are based on physical commodities that include items such as gold, silver, other precious metals, and grains.
Various types of food items, such as com or pork bellies, are also considered to be commodities.
Commodity futures are based on the perceived worth of the goods today and at some future point in time.
Commodity futures are one of the most active forms of investment trading today.
Some investors choose to engage solely in commodity futures as a means of generating revenue from an investment portfolio.
Others choose to vary investments somewhat, including stock and bond options along with commodity futures in their investment strategies.
While carrying some degree of risk, commodity futures often are less volatile than some other forms of investments.
Without the occurrence of some catastrophic event that greatly diminishes the physical commodity, the performance of commodity futures tends to be predicted with relative ease.
Features of Commodity Futures Markets
At this point, it is worthwhile to recapitulate some of the distinguishing features related to the functioning of commodity futures markets:
1. Margins: In the futures market, margin refers to the initial deposit of good faith made into an account in order to enter into a futures contract.
This margin is referred to as good faith deposit because it is this money that is used to debit any losses.
Whenever a futures position is opened, the futures exchange will state a minimum amount of money, the initial margin that must be deposited into the account.
When the contract is liquidated, the initial margin that has been adjusted for any gains or losses that have occurred over the span of the futures contract is refunded.
In other words, the amount in the margin account changes daily as the market fluctuates in relation to the futures contract.
The minimum-level margin is determined by the futures exchange and is usually 5% to 10% of the futures contract.
The predetermined initial margin amounts are continuously under review, and, in times of high market volatility, initial margin requirements can be raised.
2. Leverage: It refers to having control over the large cash value of a commodity with comparatively small levels of capital.
In other words, with a relatively small amount of cash, one can enter into a futures contract that is worth much more than what has to be paid initially (as a deposit into the margin account).
It is said that in the futures market, more than any other form of investment, price changes are highly leveraged, meaning, a small change in a futures price can translate into a huge gain or loss.
Futures positions are highly leveraged because the initial margins that are set by the exchanges are relatively small compared to the cash value of the contracts in question (which is part of the reason why the futures market, though useful, is also very risky).
The smaller the margin in relation to the cash value futures contract, the higher the leverage.
3. Pricing and Limits: While contracts in the commodity futures market are the result of competitive price discovery, prices on futures contracts have a minimum amount that they can move.
These minimums are established by the futures exchanges and are known as ticks.
Futures prices also have a price change limit that determines the prices between which the contracts can trade on a daily basis.
The price change limit is added to, and subtracted from, the previous day’s close, and the results provide the upper and lower price boundary for the day.
The exchange can revise this price limit if it feels necessary. Exchanges may not have price limits on the first trading day of a new contract.
It is also not uncommon for an exchange to abolish the daily price limit in the month that the contract expires.
This is because trading is often volatile during this month, as sellers and buyers try to obtain the best price possible before the expiration of the contract.
Trading shuts down, if prices reach their daily limits, so that there may be occasions when it is not possible to liquidate an existing futures position at will.
4. Regulation: In order to avoid any unfair advantages, the Regulator and the commodity futures exchanges impose limits on the total amount of contracts or units of a commodity in which any single person can invest.
These are known as position limits, and they ensure that no one person can control the market price for a particular commodity.
Requisite in Commodity Futures Trading
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:
1. Contract Unit: It specifies that how much quantity is contracted in the future contract to make a settlement at the expiration of the future contract.
2. Quotation of Price: Future prices 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.
3. Minimum Price Change: Exchanges establish the minimum amount that the price fluctuates upward or downward. The process of establishing the minimum amount by the exchange is known as “TICK”.
4. Daily Price Limits: Exchange establishes daily price limits for trading in futures 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 have 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 are subject to change.
5. Position Limit: Exchanges and the CFTC establish limits on the maximum speculative position that one person has 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.