How to Trade in Commodity Futures?

5paisa Research Team Date: 23 Mar, 2022 02:12 PM IST

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Content

Introduction
What are Commodity Futures?
How Do These Contracts Work?
Players Involved in Commodity Futures
Considerations Before Entering Contracts
The Trading Process
To Conclude

Introduction

The commodity future is an attractive option for prospective investors who are looking to enter the market of commodity trading. The reasonably high risk that comes with committing to a future contract is offset by the safety such a contract offers in the highly volatile market of commodity pricing.

With Inflation rates skyrocketing around the world and uncertainties in the market increasing day by day, commodity futures contracts can be a great option to consider if one is looking to protect themselves against the windfall losses that can occur without warning.

To help you get into the world of commodity futures trading and understand what exactly the market entails, let us look at how exactly trading in commodity futures works, and how you can make the best use of this understanding.

What are Commodity Futures?

Commodity futures are essentially agreements between the buyers and sellers of various commodities, wherein they agree to buy or sell a certain specified amount of a commodity at a predetermined date in the future. They are based on the concept of Futures contracts, where the value of the assets being bought/sold is derived and pre-determined before it comes into fruition.

The main reason people enter such contracts is to hedge, i.e., protect the investment they’re making into the commodity against volatile market conditions like price inflations and windfall profits/losses. Investors and speculators also use them to bet on or against the value of the asset in question, thus profiting from price fluctuations if their predictions are right.

How Do These Contracts Work?

Commodity futures get their identity from the expiration date that is agreed upon, more specifically, the expiration month. For example, if the realization date for a given contract is in April, it is an April futures contract. Most futures contracts are realized before the expiration date. Some of the common commodities traded in this market include:

• Cotton.
• Gold.
• Silver.
• Petroleum.
• Wheat.
•  Corn.
•  Silver.
•  Natural Gas, etc.

Since commodities futures investing can have extremely significant amounts of volatility in their price, such contracts can result in large gains as well as losses.

Players Involved in Commodity Futures

A) The most numerous participants that enter contracts for commodities futures investing are usually institutional and commercial producers of commodities. This largely means retail traders, but also includes a few corporate and government players.

B) Thus, the market mainly involves "Hedgers" of these commodities. These hedgers trade the volatile possibilities of the future in return for maximizing the potential value of their assets under the prevailing conditions in the financial market while avoiding the risks of price changes.

C) Other than the producers, there are “Speculators”. These speculators attempt to profit from price changes and their interactions with these contracts.

D) The Commodity exchanges of the respective country's financial system. In India, commodity futures exchanges take place on the Multi-Commodity Exchange (MCE) and the National Commodity and Derivatives Exchange (NCDEX).

Considerations Before Entering Contracts

A) Make sure you underline your goals and are aware of the extent of your available financial resources.

B) Prepare yourself to be able to bear the possible losses and make sure you can afford such a situation if the need arises.

C) Thoroughly go through all the risk disclosures documents that your broker provides.

D) Before you purchase a contract, understand the obligations that come with it.

The Trading Process

With recent advancements in the financial system, the trading system has been greatly streamlined. The online proccess of commodity futures investing is pretty straightforward.

A) Once you have chosen a reliable commodity broker, open a trading account with them. This process includes filling the relevant documentation and funding the account. Note that the broker must be registered with the National Agency in charge (SEBI in India).

B) Next, Choose the asset in the commodity market that you want to enter in a futures contract in, and choose the commodity exchange accordingly. In India, MCX is the listed exchange for metals and energy. Agri commodities are entered into on the NCDEX.

C) Develop a plan for trading that considers all your goals and objectives, along with the personal risk involved. If you’re new to trading in this market, it is recommended to start dealing with smaller amounts, so your risk profile is lower, at least until you start to develop relevant experience. It is also recommended to enter such contracts judiciously, as the trade process can get overwhelming.

D) Begin Trading.

To Conclude

Commodity futures contracts can be a great way to enter a standardized market for your commodities and hedge your products against the risks of price volatility and fluctuations, especially considering just how volatile the world economy is currently.

Although this volatility can also be a double-edged sword and result in losses upon entering a contract, they are still great ways of profiting from the market if you have a decent knowledge of the market. If you can carry on trading with caution and the drive to learn and observe the movement in markets, you stand to gain a lot.

More About Commodity Trading Basics

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