What are Commodity Futures?
For those who seek for diversification of their portfolios and are keen on looking beyond traditional asset classes such as equities and debt, can consider commodity futures. Just like in the equity market, the underlying instruments are shares, in the case of commodity market, the underlying instruments are commonly traded goods such as wheat, jute, cotton and sugar and a host of other commodities. It also includes bullion like gold and silver.
A commodity futures contract, thus, is a commitment made between the buyer and the seller to either make or accept (as the case may be) delivery of a pre-specified quality or quantity of a commodity at a future date at a price that has been pre stipulated. This is called the contracted price. When the date that has been agreed upon arrives, both the participants can liquidate their positions by way of a cash settlement at the price between the contracted price and the liquidated price on the expiry date of the contract.
Alternatively, a physical delivery of the commodity can also be made or taken when the contract expires. In that case, both parties must inform the exchange and own the requisite warehouse receipts of the location in which the delivery must take place.
Commodities futures are popular with people who have knowledge of the underlying commodity. For instance individual farmers or food processing companies operate as hedgers in the commodity market to protect themselves from the risk of a price fluctuation. Take for instance, an example of a ata (wheat flour) manufacturer A. A is expecting a good crop of wheat by March 2015, but is scared that the prevailing price of wheat may decline by then.
- A therefore enters into a contract with B (another ata manufacturer) to deliver 50 kgs of wheat at the current market price.
- B agrees to such a contract because he believes that the price of wheat will escalate over the same time frame.
- In trading parlance, A is said to be going short while B is considered to be going long
- On the expiry date of the contract, if the price of wheat actually declines, A makes a profit and pockets the difference between the contracted price and the liquidated price.
- On the other hand if the prices go up A will need to pay this difference to B.
Hedging with commodity futures
This is a mechanism that is used by market participants to cover their price risk. The relationship between future and cash prices is determined by cost of carry. By taking an opposite position in the futures market, a participant can hedge his price risk in the cash market.
Let’s take an example step by step
- On Dec 1, 2014 A purchases 10 tons of jeera seeds in the spot market @ 4000
- To hedge his price risk, he sells 10 contracts each of one ton in the futures market at the prevailing price
- Assuming that the ruling price in May 2015 will be 4750 p.q. A locks in spread of 750 p.q about 18% for 6 months.
- If the spot price drops to 3900 p.q in the month of April, and A decides to sell his stock he incurs a loss of 100 p.q. on his physical stock. He also loses the amount incurred on the cost of carry or the amount spend for holding the stocks.
- However, one must bear in mind that the spot and the future prices move in tandem so the futures price is likely to decline from 4750 p.q to 4500 p.q.
- If A liquidates his contract by entering into a purchase agreement at 4500 p.q, he gains a profit of 250 p.q in the futures segment.
- Thus, as we can see that by taking opposite positions simultaneously in two markets, he can hedge his price risk.
The Safety Aspect
Commodity futures are always traded on an organized exchange such as MCX, NCDEX or NMCE in India. When a buyer and seller enter into a futures contract with an exchange, they must make a deposit of money which is called the “initial margin”. The exchanges also prescribe a “maintenance margin” which is the lowest amount an account can reach before it needs to be infused with funds again. The margin you need to maintain varies from 5-10% of the total value of the contract (differs across different categories of commodities and exchanges). The position of the investor is “marked to market” daily and any profit or loss (depending on the spot price) is adjusted to his margin account.
Once the margin has been deposited, one can begin trading through a broker. The key to a good trading plan is research. For instance at Beeline we specialize in research and with our analysis of price movements, we can devise an apt trading plan for you.
Although, commodities seem unfathomable and risky to most retail investors, commodity futures are in fact highly standardized instruments that operate in a regulated market environment. The futures market is closely regulated by the Forward Markets Commission in India (FMC) that ensures fair practices in the market. The counterparty risks are also eliminated in the trading of commodity futures as exchanges work in tandem with clearing houses to ensure that terms of futures contract are fulfilled.
The Benefits of Trading in Commodity Futures
The commodity market is an organized market with many unique features which can be particularly beneficial to particular classes of investors.
If you are an importer or exporter of any particular agri commodity, commodity futures can help you hedge against price fluctuation. If you are an exporter, you can use the futures markets effectively to get an indication of the price of the commodity that is likely to prevail in the future. This in turn enhances your chances in securing a contract by quoting a realistic price. On the other hand an importer can benefit by protecting against price uncertainities in local markets.
If you are a Farmer
- You can use commodity futures to take effective positions and lock in the price for your produce. This will help you in case the price comes down substantially at the time of harvest.
- At the time of harvest, you can sell your commodity futures, thus assuring a demand for your produce.
If you are an industrialist, and a regular commodity is your raw material you can
- Control your cost- Any sudden hike in the price of your raw materials may force you to pass on the price hike to your customers. If you take position in the commodity futures market, you can control the cost of your raw material by hedging your price risk.
- A shortfall in the supply of raw materials can hamper your business in a major way. To avoid this and ensure a continual supply of raw materials you can opt to take the delivery of a fixed quantity of the particular commodity at a pre stipulated price at a specific location, thus ensuring that there is no fear of a shortfall.
For Investors, Commodities can be a good investment because
- They offer optimum diversification and are a different asset class altogether that is not influenced by equity and debt.
- They are less prone to price manipulations
- The leverage opportunities are maximum in the commodity markets as the margins as far lesser as compared to the equity derivatives market.
- Like any other asset class, commodities are prone to market risks or loss on account of adverse movement of price.
- If the markets are illiquid, unwinding transaction may be a little difficult thus posing some liquidity risks.
- Rarely there may be some legal risks or change in a regulatory framework that may disallow some transactions.
- Operational difficulties may arise at certain times due to some infrastructure breakdown like failure of electricity.
The risks having been stated, we must also bring to your notice that there is enough statistical evidence to prove that commodities derivatives are less riskier than equities as they are less volatile. Besides, the market is always under strict vigilance from the regulatory authorities making them free from manipulation. Commodities as a segment can thus be an exciting investment avenue for those who are keen on diversifying their portfolios.
