Commodity futures might seem to be a fashionable idea to most but, it goes way back in time in India. There was already a cotton futures exchange in 1875! However, futures in essential commodities were discontinued in the 1960s because of fears of speculative activity and hoarding. It wasn’t until 2002 that commodity futures were reintroduced in India.
What are commodity futures?
So, what are these futures? Let us first understand the concept of futures contracts. These are derivatives whose value is determined by that of an underlying asset. A futures contract allows a buyer or seller to buy or sell a commodity at a predetermined price in the future. Commodity futures are available for a variety of products like wheat, cotton, petroleum, gold, silver, natural gas, and so on.
For example, a wheat farmer, who is expecting a harvest of 100 quintals may want to sell his product at Rs 2,000 a quintal. However, wheat prices have been continuously fluctuating, and the farmer feels he may not be able to get the amount he wants. So, to hedge against price fluctuations, he enters into a futures contract to sell 100 quintals at Rs 2,000 a quintal at harvest time, a month from now. In the meantime, wheat prices fall to Rs 1,500 a quintal. However, the farmer can exercise his futures contract and get Rs 2,000 for the produce, thus gaining Rs 50,000. The downside is if wheat prices go up to Rs 2,500, he will not enjoy the benefit of the price increase as he will still have to sell the wheat at Rs 2,000. He will stand to lose Rs 50,000. However, producers prefer assured prices and are willing to sacrifice risky windfall profits to get a price they want.
Hence, commodity futures help producers and buyers to hedge against price volatility. Of course, producers, end-users, and traders are not the only parties who benefit. Speculators too can enjoy the benefits of price fluctuations and make money even though they may not have the slightest interest in the commodity itself!
Countries, too, are involved in trading such futures; for example, vast importers of petroleum. Any changes in price affect their economies. For protection against this kind of price volatility, they enter into petroleum futures contracts, which mitigates the price risk to some extent.
Commodity futures trading
Commodity futures are bought and sold in commodity exchanges. These include exchanges like the New York Mercantile Exchange (NYMEX), London Metals Exchange (LME), Chicago Mercantile Exchange (CME) etc. In India, trading in these type of futures takes place on exchanges like the Multi-Commodity Exchange (MCE) and the National Commodity and Derivatives Exchange (NCDEX).
Here are some of the features of commodity futures trading:
- Exchanges: Commodity trading is very organised and takes place in commodity exchanges like NYMEX in the USA, and MCX and NCDEX in India.
- Standardised: The contracts are highly standardised. The quantity, quality, price, and time are determined by the exchanges in which they are traded. For example, gold is available in lots of 1 kg, 100 gm, guinea (8 gm) and petal (1 gm) portions. The gold must be in numbered bars and of 995 purity.
- Leverage: Before you can trade in these futures, you have to deposit what is called an initial margin with the broker. This is a percentage of your exposure. Let’s say the margin is 4 percent and you are trading worth Rs 10 crore, then, your initial margin would be Rs 40 lakh. Since margins are quite low, you can buy and sell in large volumes. This is called leveraging. High leverages increase the chance of profit and losses too. If your hunch is right, you can make windfall profits. But if you lose, you lose a lot.
- Regulated: Commodities markets are monitored to ensure fair practices. In India, the body that governed the commodity futures trading used to be the Forward Markets Commission. But in 2015, it was merged with the Securities & Exchange Board of India (SEBI).
- Physical delivery: Buyers have the choice of accepting physical delivery on the expiry of these contracts. If buyer doesn’t seek physical delivery, there is an option to square off the transaction before its expiry date.
- Zero-sum game:These futures are a zero-sum game. When you win, someone else loses.
Advantages of commodity futures trading
- Price discovery: Trading in these futures leads to price discovery. Prices are accessible, and liquidity ensures the right rates.
- Standardised:Since these types of contracts are regulated, it’s easier to compare prices in markets around the world.
- Hedging: These futures enable hedging against price fluctuations which eliminate uncertainty for producers, traders and end-users.
- Benefits for investors: Trading (in these futures) benefits investors as they can diversify their portfolios. For example, since gold prices move in the opposite direction of many other assets, investors can use gold futures to hedge their bets and protect their portfolios.
Disadvantages of commodity futures trading
- Leverage: The possible high leverage makes it reasonably risky. If you don’t get it right, you could end up losing a lot of money.
- Volatility: These futures contracts are highly volatile. Commodity markets are influenced by events from around the world, and price changes can happen anytime.
- Speculation: Speculators could take over a commodity market and artificially inflate or deflate prices.
There are apparent advantages of trading in commodity futures. The opportunities to make profits are fairly abundant as most commodities will continue to be in demand for many years to come. The risks are also high. You should go into commodity trading only if you have a large appetite for risk, can keep a cool head in tense situations, and can stay abreast of international developments that could affect the price. Usually, most of these futures markets are dominated by large institutional players with considerable expertise. But there’s no reason for retail investors to not benefit. All you need is a little bit of caution and the ability to quickly absorb a lot of information.