A commodity future is a standardised contract between two parties to buy or sell a specific quantity of a commodity at a specified price on a specified date in the future. Commodity futures are traded on an exchange and used to hedge against price fluctuations in the underlying commodity.
Many favour trading commodity futures due to an array of benefits, including but not limited to:
Price discovery is the process by which the prices of futures contracts are determined. The price of a futures contract is based on the underlying spot price of the commodity, plus a premium or discount. The premium or discount is determined by the supply and demand for the contract.
The price discovery process helps ensure that prices for commodities are efficient and reflect all available information.
Ability to hedge
Hedging is a risk management tool that you can use to protect against price fluctuations in the underlying commodity. A hedger may enter into a futures contract to offset the risk of adverse price movements in the underlying commodity.
For example, a farmer may sell a wheat futures contract to hedge against the risk of falling wheat prices. If the price of wheat falls, the farmer will profit from the futures contract. If the price of wheat rises, the farmer will lose on the futures contract.
Access to arbitrage
Arbitrage is buying and selling a commodity in different markets to take advantage of price discrepancies.
For example, if the price of gold is higher in London than in New York, an arbitrageur may buy gold in London and sell it in New York, pocketing the difference.
Arbitrageurs are essential in ensuring that prices are efficient and reflect all available information, and commodity futures traders can achieve this on the market.
Speculation is the act of trading a commodity to make a profit from price movements. Speculators do not intend to take delivery of the underlying commodity.
Speculation is a risky activity, but it can also be profitable. Some speculators may use futures contracts to protect themselves against losses in the underlying commodity.
Liquidity refers to the ability of a market to buy and sell assets without affecting the prices. Commodity futures markets are relatively liquid, meaning they can buy and sell large quantities of commodities without significant price movements.
Someone is always willing to buy or sell a contract at the current price.
Futures contracts are flexible instruments you can use in various ways. For example, you can use them to hedge against price risk, speculate on price movements, or arbitrage prices.
You can also use them to buy or sell commodities in different markets. This flexibility makes futures contracts essential for managing risk in the commodities market.
Transparency is the degree to which information about a market is available to all participants. The commodity futures markets are relatively transparent, with prices quoted publicly and trading activity available for all to see.
This transparency helps to ensure that prices are efficient and reflect all available information.
The commodity futures markets are regulated by government agencies such as the Commodity Futures Trading Commission (CFTC) in the United States and the Financial Conduct Authority (FCA) in the United Kingdom.
These agencies help ensure that prices are fair and transparent and that trading futures is conducted safely and orderly.
Commodity futures contracts may be eligible for special tax treatment in some jurisdictions. For example, in the United States, gains from trading commodity futures are taxed at a lower rate than other investment income.
It can make commodity futures an attractive investment for taxpayers.
Access to global markets
Commodity futures give traders access to global markets. A trader can buy or sell commodities in different countries with a single contract.
It allows traders to take advantage of price discrepancies in different markets and hedge against currency risk.
Diversification is the process of spreading investment risk across several different assets. Trading commodity futures can help to diversify a portfolio and reduce overall risk.
For example, if a trader has a portfolio of stocks and bonds, they may want to add commodity futures to their portfolio to diversify their risk. As they can trade different types of commodities, this itself offers a good diversification opportunity.
The flexibility and abundance of benefits commodity futures trading carries makes it very appealing for a diverse type of traders. However, before investing your capital in any asset, it is important to do sufficient research and ensure you understand how trading works before opening a position. Only when you have done your homework should you enter into the markets.