A commodity futures contract is an agreement to buy or sell a predetermined amount of a commodity at a specific price on a specific date in the future. Commodity futures can be used to hedge or protect an investment position or to bet on the directional move of the underlying asset.
Many investors confuse futures contracts with options contracts. With futures contracts, the holder has an obligation to act. Unless the holder unwinds the futures contract before expiration, they must either buy or sell the underlying asset at the stated price. Commodity futures can be contrasted with the spot commodities market.
Commodities futures contracts are agreements to buy or sell a raw material at a specific date in the future at a particular price. The contract is for a set amount. It specifies when the seller will deliver the asset. It also sets the price. Some contracts allow a cash settlement instead of delivery.
The three main areas of commodities are food, energy, and metals. The most popular food futures are meat, wheat, and sugar. Most energy futures are oil and gasoline. Metals using futures include gold, silver, and copper.
Buyers of food, energy, and metal use futures contracts to fix the price of the commodity they are purchasing. That reduces their risk that prices will go up. Sellers of these commodities use futures to guarantee they will receive the agreed-upon price. They remove the risk of a price drop.
Most commodity futures contracts are closed out or netted at their expiration date. The price difference between the original trade and the closing trade is cash-settled. Commodity futures are typically used to take a position in an underlying asset. Typical assets include:
- Crude oil
- Natural gas
Commodity futures contracts are called by the name of their expiration month, meaning a contract ending in September is a September futures contract. Some commodities can have a significant amount of price volatility or price fluctuations. As a result, there’s the potential for large gains but large losses as well.
- In a price drop, the producer does not lose money. He gets the agreed-upon price.
- These contracts ensure that the commodity producer receives a fixed sales price, come harvest or selling time.
- Producers or companies can make better production plans.
- Producers can limit their risk, in case of a price drop.
- Trading in these contracts is very risky. World commodity prices are highly volatile.
- In the event of a price increase, producers can miss out on considerable gains. Contract prices are fixed.
- Commodity prices are influenced by world events, traders’ emotions, and market speculations, even when demand and supply remain at the same level
- This investment type is best left to experts.