25 July 2015
Sales Trader, Client Trading Services, Saxo Capital Markets
This is a short guide to trading commodity futures. In it we will cover the basics from what a commodity future is to how it might be incorporated in a trading strategy.
What are commodity futures?
A commodity future is an agreement between two parties - the buyer and the seller - to trade an agreed amount of a commodity - oil, gold, metal, grain etc - at a specified price and date in the future.
How do commodity futures work?
Most futures contracts are bought and sold on margin, so only a small fraction of the face value of the contract is paid upfront, which enables smaller investors to take bigger positions. As a trader you'll be either a hedger or speculator;
Hedgers are usually trying to protect a position and are therefore not necessarily trying to make money.
Speculators usually take a position in the market in the expectation that the price of a commodity will move one way or another, in their favour.
What are the benefits/risks in trading commodity futures?
A key characteristic of commodity futures is leverage. Since only a fraction of the face value of the contract needs to be paid up-front, profits and losses are magnified. That is a huge risk too.
Commodities futures, which are traded on the open market, should accurately reflect the anticipated future demand of a commodity. Notwithstanding future "shocks" they can be a good forecaster for the future value of a commodity.
Crude oil is one of the most commonly traded futures products and is seen as a staple financial instrument for hedgers, traders, and investors around the globe.
Why trade commodity futures?
Day traders are almost certainly speculators; they look to make money out market volatility, betting that prices will go either up or down.
A buyer of a future contract may make money if the price of the underlying commodity goes up; they get the product at the lower price agreed in the contract and then sell the commodity at the higher price achieved in today's market.
On the other hand, a seller of a future may make money when the price of the underlying commodity falls; they can buy the commodity at the today's lower market price, and sell it to the buyer at the higher, agreed-upon price.
Speculators will rarely look to take possession of the underlying commodity. Instead they will look to sell the contract before the agreed expiry date, whether at a profit or a loss.
A day trader may, however, need to consider the expiry date of the contract in order to close it out, otherwise they risk having to deliver the underlying commodity.
How can commodity futures be included in a trading strategy?
As commodities future speculator you're trying to predict the future price of a commodity. For example: if you think the price of oil is due to rise over the next six months, you would buy an oil future locking in the price of a barrel of oil now for which you will pay for later (effectively locking-in a discounted rate if you are correct and the oil price rises).
If the oil price does rise, you can either sell the contract on at a profit or buy the underlying stock at today's cheaper price and sell it to the contract seller who is obliged to buy it off you at the more expensive price agreed upon earlier. The opposite is true if you thought the price of oil was set to fall.