Introduction To Commodity Futures Market Place

The futures market is a centralized market place for buyers and sellers from around the world who meet and enter into commodity futures contracts. Pricing mostly is based on an open cry system, or bids and offers that can be matched electronically. The commodity contract will state the price that will be paid and the date of delivery. Almost all futures contracts end without the actual physical delivery of the commodity.

What Exactly Is a commodity Contract? Let's say, for example, that you decide to subscribe to satellite TV. As the buyer, you enter into an agreement with the company to receive a specific number of channels at a certain price every month for the next year. This contract made with the satellite company is similar to a futures contract, in that you have agreed to receive a product or commodity at a later date, with the price and terms for delivery already set. You have secured your cost for now and the next year, even if the price of satellite rises during that time. By entering into this agreement, you have reduced your risk of higher prices.

That's how the futures market works. Except instead of a satellite TV provider, a producer of wheat may be trying to secure a selling price for next season's crop, while a bread maker may be trying to secure a buying price to determine how much bread can be made and at what profit. So the farmer and the bread maker may enter into a futures contract requiring the delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price that both parties believe will be a fair price in June. It is this contract that can then be bought and sold in the commodity market.

A futures contract is an agreement between two parties: a short position, the party who agrees to deliver a commodity, and a long position, the party who agrees to receive a commodity. In the above scenario, the farmer would be the holder of the short position (agreeing to sell) while the bread maker would be the holder of the long (agreeing to buy). (We will talk more about the outlooks of the long and short positions in the section on strategies, but for now it's important to know that every contract involves both positions.)

In every commodity contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The price of a futures contract is represented by the agreed - upon price of the underlying commodity or financial instrument that will be delivered in the future. For example, in the above scenario, the price of the contract is 5,000 bushels of grain at a price of $4 per bushel.

Profit And Loss - Cash Settlement. The profits and losses of a futures depend on the daily movements of the market for that contract and is calculated on a daily basis. For example, say the futures contracts for wheat increases to $5 per bushel the day after the above farmer and bread maker enter into their commodity contract of $4 per bushel. The farmer, as the holder of the short position, has lost $1 per bushel because the selling price just increased from the future price at which he is obliged to sell his wheat. The bread maker, as the long position, has profited by $1 per bushel because the price he is obliged to pay is less than what the rest of the market is obliged to pay in the future for wheat.

On the day the change occurs, the farmer's account is debited $5,000 ($1 per bushel X 5,000 bushels) and the bread maker's account is credited by $5,000 ($1 per bushel X 5,000 bushels). As the market moves every day, these kinds of adjustments are made accordingly. Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day. In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides to sell the stock or cover his or her short position.

As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market. Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. So on the date either party decides to close out their futures position, the contract will be settled. If the contract was settled at $5 per bushel, the farmer would lose $5,000 on the contract and the bread maker would have made $5,000 on the contract.

But after the settlement of the wheat futures contract, the bread maker still needs wheat to make bread, so he will in actuality buy his wheat in the cash market (or from a wheat pool) for $5 per bushel (a total of $25,000) because that's the price of wheat in the cash market when he closes out his contract. However, technically, the bread maker's futures profits of $5,000 go towards his purchase, which means he still pays his locked-in price of $4 per bushel ($25,000 - $5,000 = $20,000). The farmer, after also closing out the contract, can sell his wheat on the cash market at $5 per bushel, but, because of his losses from the futures contract with the bread maker, the farmer still actually receives only $4 per bushel. In other words, the farmer's loss in the commodity contract is offset by the higher selling price in the cash market--this is referred to as hedging.

Now that you see that a futures contract is really more like a financial position, you can also see that the two parties in the wheat futures contract discussed above could be two speculators rather than a farmer and a bread maker. In such a case, the short speculator would simply have lost $5,000 while the long speculator would have gained that amount. (Neither would have to go to the cash market to buy or sell the commodity after the contract expires.)