Understanding Futures and Commodities
- Futures contracts can be used to help protect against the risk of fluctuating commodity prices.
- Futures speculators may be able to profit from movements in commodity and financial markets.
- Futures are a form of derivatives; they can be highly unpredictable, and you could lose all or more than your initial investment.
What futures contracts are and how they work
Futures trading began with traditional agricultural commodities, such as grains and livestock. Exchange-traded futures have expanded to include metals, energy, currencies, equity indexes, and interest-rate products, all of which are traded electronically.
Futures contracts are legal obligations to buy or sell a commodity or security at a date “in the future.” The buyer agrees to purchase the commodity or security at a predetermined future date and price, and the seller agrees to deliver.
The contract is standardized according to quality, quantity, and delivery time and place. The only remaining variable is price. It is determined through an auction-like process that occurs via an electronic trading platform or, to a lesser extent, on an exchange trading floor.
It’s important to understand that the underlying products specified in the contract are seldom physically delivered to the buyer. Instead, if you bought (“went long” on) a futures contract, you could sell the same contract before the contract enters the delivery period, which usually occurs in the last few weeks of the contract. This would allow you to close out your contract and avoid having to take physical delivery of the goods.
Initial margin requirements
Leverage on futures contracts is created through the use of a performance bond, known as margin. This is money both the buyer and seller of a futures contract deposit to ensure their performance of the contract terms.
The performance bond may represent only a fraction of the contract’s total value – often 3% to 12%. This makes futures a highly leveraged trading vehicle. As a result, a trader can have greater flexibility and capital efficiency, but it can also potentially lead to major losses. In addition, because of this leverage, a trader could lose all or more than his/her initial deposit.
Using futures as a hedge
Hedgers have a position in the underlying commodity. They use futures to manage the risk associated with an adverse price change.
For example, a wheat farmer may sell futures contracts on his/her wheat crop several months ahead of harvest to help reduce the risk of a drop in wheat prices.
A business may use futures to manage against price increases in a commodity that’s likely to impact its profitability in the future. An airline, for example, can use futures contracts to reduce the impact of rising fuel costs.
Speculating in futures
Much of the activity in the futures market comes from traders whose goal is to profit from the change in a contract’s value.
For example, a futures trader might purchase a December crude oil contract (or another month; contracts are identified by delivery months) with the expectation the price of crude oil will go up and increase the contract’s value. If that occurs, the trader could then sell a December crude oil contract to close out the position. This relieves the trader from the obligation to take delivery of the oil, and the trader enjoys a profit (minus commissions and other fees) off the transactions.
However, should the price of crude oil go the other way, the trader would experience a loss. Also, it is possible to lose money in a futures contract even if the underlying spot price moves in a favorable direction. This is because of other factors in the futures market.
Know the risks
This type of trading and investing is not for everyone.
Futures are a form of derivatives trading. In other words, the value of the contract an investor purchases is based on (derived from) the price of the contract’s underlying commodity, currency, index, etc.
The futures and commodities markets can be highly unpredictable. Prices often move dramatically. This can happen so quickly, you may not have time to “cover” or get out of your obligation. You may lose your entire investment.
In some cases, you may lose even more than you invested. There can be times when you can have trouble liquidating your futures contract, which may limit your access to cash.
You should know that using leverage can lead to extreme volatility. Prices may plummet and rise, making it extremely difficult to determine when to get out.
Factors to consider in determining if appropriate for you
Before opening an account, it is important to consider several factors to determine if futures are appropriate for you:
- Financial experience — Have you had experience with derivatives, commodities, futures, and options?
- Investment goals — Are you accessing the futures market to address a particular exposure?
- Risk tolerance — Do you have a complete understanding of the risks involved in futures investing?
- Financial resources — Can you withstand the loss of some, all, or more than your investment?
Also keep in mind futures are not covered by the Securities Investor Protection Corporation (SIPC), which helps protect investors from losses resulting from the bankruptcy of their brokerage firm.
Investing in futures
You can learn more about investing in futures through your Financial Advisor. It is a good idea to talk through whether this type of investment fits your specific situation. Your advisor can assess your risk tolerance and explain some of the potential outcomes you might encounter.
- Ask your Financial Advisor for more information about futures.
- Make sure you understand the risks of futures investing.
- Talk with your Financial Advisor about whether futures investing may be right for you.
Investments in commodities and futures are speculative, involve substantial risk, and are not appropriate for all investors. Investors should be aware that such investments can quickly lead to large losses as well as gains. Additionally, restrictions on redemptions may affect investors’ ability to withdraw their participation. Further, there may be substantial fees and expenses.