What Are Commodity Futures? Meaning, Benefits & How to Trade

In this article, we will explore in detail what Commodity Futures are, how to trade them, and what value they can bring to a trader’s portfolio. Trading in commodity futures can open avenues for hedging and other types of investment opportunities.

Understanding Commodities

The official Multi Commodity Exchange (MCX) website describes commodities as “Any good having commercial value, which can be produced, bought, sold, and consumed. In other words, the commodity is a good used in commerce that is interchangeable with other commodities of the same type. When traded on an exchange, commodities must also meet specified minimum standards, sometimes known as the basis grade.” Products like crude oil, natural gas, precious metals, agricultural products, etc, are classified as commodities.

What is Futures Contract

A futures contract is one where two parties enter into a contract to buy and sell a predetermined quantity of a commodity at a predetermined price on a specified date in future. Future contracts are traded on exchanges.

What is Commodity Futures?

Commodity futures are a vital element in trading, providing ways to hedge, invest or speculate in commodities like crude oil, gold, silver, or agricultural produce. Grasping the meaning of commodity futures is simple. They are regulated contracts for purchasing, or selling a fixed quantity of any commodity at a pre-decided price on a future date.

Commodity futures help investors hedge against price risk in that commodity. This is particularly useful for producers of these commodities.

How Commodity Futures Work?

A futures contract starts with an agreement between two participants on the terms of the contract and the subsequent daily settlement of the contract until the contract’s expiry date. Daily settlement in futures contracts eliminates the credit risk. Credit risk is the risk that one of the parties to the contract may default on its contractual obligation.

Purpose of Commodity Futures

The fundamental purpose of commodity futures is binary: risk management and price discovery. For producers and consumers of commodities, these contracts provide the option to set prices and protect against negative price movements.

For example, a natural gas company could utilise futures to secure a selling rate, mitigating the uncertainty of price fluctuations. Commodity futures are critical in deciding the fair market price of any commodity based on its current supply and demand, offering significant insights for investors and traders.

Advantages and Disadvantages of Commodity Futures

Let us discuss some vital pros and cons of commodity futures –

Advantages:

• Risk Management: The most vital benefit of commodity futures is the capability to hedge against adverse price actions, providing a safety net.
• Leverage: Futures contracts allow traders to control large amounts of a commodity with a fractional investment.

Disadvantages:

• High Risk: Commodity futures may carry high risks.
• Leverage:  It is a double-edged sword. While it can provide high profit, it can also amplify financial loss, sometimes leading to significant capital depletion.

Steps to Trade Commodity Futures

Listed below are the steps required to trade in commodity futures.

• Understand the Market: Familiarise yourself with the commodity you choose to trade and the factors influencing its price action. This fundamental understanding is critical for taking calculated risks and preserving capital.
• Choose a Broker: Choose a reputable and dependable broker who provides access to the commodity exchanges such as MCX.
• Open a Trading Account: After you open demat account, ensure your trading platform is equipped with the necessary tools and resources to conduct fundamental and technical analysis before a trade. This account will be used to trade on commodity exchanges.
• Develop a Trading Strategy: Identify your trade. Are you hedging risk or speculating for profit? This trading strategy must align with your financial goals and risk appetite.
• Monitor and Adjust:  Monitor your trade and its trend. Staying informed about market fluctuations and be ready to adjust your positions accordingly to boost profits or avoid losses.

Trading Strategies for Commodity Futures

Efficient trading strategy for commodity futures must include a cohesive mix of technical and fundamental analysis, risk management and market research. Here are a few tips:

• Trend Following This strategy aims to analyse current market trends and follow the prevailing momentum. Traders can buy when the price action is moving upward and sell when it is moving downward.
• Hedging: This strategy is quite popular with traders in the commodity futures market. Hedging is used to lock prices and provide protection against adverse price action. It is used for risk management rather than booking profits.

Investing in commodity future basically allows the traders and investors to hedge risks by forecasting price fluctuation trends. Thus, it is an investment instrument that allows the investor to relatively reduce their risk exposure while commodities trading like specific food, fuels, currencies, precious metals and even commodities like semiconductor chips.