Commodity futures
Hedging and speculation in futures
1. What is a commodity futures contract?
A commodity futures contract is a standardized contract set by a particular futures exchange that includes the size (1000 barrels, 5000 bushels, 5000 ounces, etc.), the place where delivery can be made, the type and quality of the commodity to be delivered, and the price of the transaction.
The futures contract is negotiated on a regulated futures exchange, which is a central market place where all buy and sell orders are routed to a single location on the exchange.
A transaction in the commodity futures market is made on the trading floor (or in the trading computers) of the exchange between brokers who are members of the exchange that particular commodity is trading on. The seller has a broker and the buyer has a broker. They transact an order for a purchase and sale.
The buyers and sellers of commodity futures contracts have obligations. The buyer is obligated to take delivery and pay for the cash commodity during a specific time frame. The seller is obligated to deliver the commodity, for which he will be paid the price that was decided in the exchange pit by the brokers. (Sometimes the price can be more or less depending on the grade or quality of the specific material.) The buyer and seller can eliminate their obligation by offsetting their trade at the exchange before the contract comes due. This is what most speculators do in the commodity markets. (1)
2. How prices are determined
Prices are determined solely by supply and demand, not by commodity exchanges themselves. If there are more buyers than there are sellers, prices will be forced up. If there are more sellers than buyers, prices will be forced down. Buy and sell orders, which originate from all sources and are channeled to the exchange trading floor for execution, are actually what determine prices. (2)
3. The clearing house
Each futures exchange has its own clearing house. All members of an exchange are required to clear their trades through the clearing house at the end of each trading session, and to deposit with the clearing house a sum of money (based on clearinghouse margin requirements) sufficient to cover the member's debit balance.
Because of this, the clearing house is placed in a position of being responsible to all members for the fulfillment of contracts.
4. Hedging and speculation in futures
There are speculators and hedgers that trade in the commodity markets. A hedger is not interested in making a profit off the movements in price of a commodity futures contract, but rather in shifting his risk of loss on the commodity itself due to adverse price change. Speculators will buy and sell futures, or options on futures, for the purpose of making a profit. They will buy futures (a long position) when they think prices will rise, or they will sell futures (a short position) when they think prices will fall. Both speculators and hedgers add volume to a market, making it a more liquid market to trade.
Most individuals who open commodity trading accounts are speculators looking to benefit off of the price movement of the commodity being traded. Farmers, oil operators, cattle companies, etc, could open a commodity futures trading account looking to be a hedger, and reduce their risk of price movement. (1)
5. How short sales are made
To sell a commodity future short, one sells first and then closes out (or covers) this sale with an offsetting purchase at a later date. One need not have, or own, the particular commodity involved. The practice of selling short is a common one in futures markets. Those who sell short (with the exception of those placing hedges to protect a cash commodity position) do so in the expectation that prices will decline and that they will be able to buy later at a profit. A short position in the market is of course just the opposite of a long position, which involves buying first and closing out (or liquidating) later with an offsetting sale. (1)
6. Margin requirements
When one establishes a position in a commodity future, either long or short, it is necessary to deposit with the broker a sufficient amount of money to protect the position. It is actually to protect the broker against loss in the event the trade entered into is unprofitable. This deposit is referred to as a margin. The margin required of a customer by a broker is a different margin than that required of the broker by the clearing house. Both margins server the same purpose though. They insure that obligations arising from commitments in commodity futures are fulfilled.
There is no interest charged on the difference between the market value of a futures contract and the margin deposited to trade it.
The amount of margin that one is required to deposit with the broker in order to trade in commodities is usually 10 percent or less of the market price of the commodity. Exchange regulations prescribe the minimum margins that brokers require of customers. These minimums are changed from time to time, depending on market conditions.
After making an original margin deposit with a broker, one is obligated to add this deposit only if: he increases the size of his market commitment OR there is a loss in his existing position due to prices moving in a direction contrary to that which he had expected.
The usual procedure is for the broker to call for additional margin when the original margin has been reduced (by an adverse price move, usually calculated as of the close of the market session) to roughly 70 to 75 percent of the margin originally deposited. The margin call is normally for the amount needed to bring one's margin back up to the original requirement. (2)
7. References
(1) The Mechanics of the Commodity Futures Market - What They are and How They Function, http://www.turtletrader.com/beginners_report.pdf
(2) The Basics of Commodities Futures Trading, http://www.unitedfutures.com/commodities-trade.htm
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