A popular question I hear is, “What is a Commodity Futures Contract?” This is a fair question, considering most investors are more familiar with stocks, options and Forex markets. Let’s look inside the Commodity Futures market asset class and remove this mystery and help answer that question in a little more detail.
Commodities are products that each of us must have everyday of our lives. Unlike a Stock of a company that makes Widgets, we must have certain Commodities to survive. Consider the house you live in:
- Lumber – Structure
- Copper – Wiring , Plumbing and PC Boards for Electronics
- Cotton – Fabrics for Furniture and Curtains
- Crude Oil – Asphalt Shingles (by-product of residue left behind after processing Crude Oil)
On a daily basis we all need food, clothing, transportation and shelter. It takes physical Commodities to produce each of these items we will need. These Commodities have been traded for well over 200 years in our country alone. Japan goes back even further with Rice trading.
For many years before Futures contracts the producers of these Commodities (farmers, miners, etc) had to endure the risk of price volatility for these Commodities. They were generally at the mercy of Mother Nature that their products would be in good supply when it was time to bring them to the market. To compound the problem the producers were all bringing their Commodities (a.k.a. Cash Commodities) to the market at the same time (harvest season, livestock slaughter, etc). We all know what happens to price when there is excessive Supply, right? Exactly, the price typically declines causing these producers to lose money.
Another problem with these Cash Commodity transactions was there were no specifications on the quality, quantity, date of delivery or legal recourse if the other party did not fulfill their obligation of the product that was being delivered to the buyer.
You can see the hardships that these businesses had to incur to do business in the Cash markets without any price protection. Keep in mind that any price increase absorbed at the wholesale level (processors) is passed on to the retail users (you and me) of these Commodities. If these producers did not have the Futures Markets to Hedge (insurance) their price risk can you imagine what prices we would be paying for items such as bread and gas today?
With all the demand for exchanging these Commodity products there needed to be some central place to conduct this business with multiple market participants in order to obtain a fair market price. It was at this point Futures exchanges were created. These exchanges provided that central location for buyers and sellers to meet and auction their products in an attempt to get the best price possible. These same exchanges created contracts on these Commodities that had specifications listed for each Commodity. At this point everybody knew exactly what they were buying or selling based on these contract specifications.
A Futures contract is a standardized contract to buy or sell a specific Commodity of standardized quality at a certain date in the future and at a market-determined price (the Futures price). Each of these contracts will then be executed on an exchange’s electronic platform or in their respective trading pits. Futures contracts are not like buying securities like a Stock or a Bond, where the prices of the Stock or Bond are the actual cash price. Futures contracts are a derivative contract. Derivative is the name used for a broad range of financial instruments that derive their value from other financial instruments (a.k.a. the underlying). In the case of Commodity Futures the underlying is the Cash Commodity.
If you would like to see a specification page for the Corn Futures contract traded at the CME Group exchange click here: Soybean Futures Contract Specifications:
Let’s review some of the specifications you might find in a Commodity Futures contract.
- Contract Size
- Deliverable Grade
- Pricing Unit
- Tick Size (Minimum Fluctuation)
- Contract Months Traded
- Trading Hours
- Daily Price Limits
- Settlement Procedure
- Last Trading Day of Contract
- Commodity Ticker Symbol
Here you find the size of the actual contract you are trading. In the case of Soybeans we are looking at 5,000 bushels per contract. This is the minimum amount you can trade for this particular contract. Unlike Equities you cannot trade partial contract sizes. There are mini and micro Futures contracts, but there is so little volume that the risk increases using these products.
The exchange determines what the quality must be of this Commodity before it can be accepted for delivery to offset a Futures contract. This allows everybody involved in the transaction to know the quality of the product being delivered. This is important to Ranchers who only want the best Corn or Soybean Meal fed to their livestock.
When reading a price quote for this Commodity you need to know what the value represents. Soybeans for example are priced in cents per bushel.
Tick Size (Minimum Fluctuation):
Each Commodity has its own unique specifications and this includes each price increment. When Soybeans move the minimum price fluctuation the move is in ¼ cent increments. This is the equivalent of $12.50 per tick. Markets can trade in larger tick increments, but never less than the minimum tick.
Contract Months Traded:
Unlike Stocks, all Commodity Futures have expirations involved with each contract. Each Commodity will have distinct contract months to trade. These months are usually related to the cycle of the Commodity. Example Corn has contract months that involve the planting season, growing season, harvest season and the livestock winter feeding season.
Each contract will have their unique trading hours. Many Futures markets are traded in two different formats – pit trading (open outcry) and electronic trading. Some Futures are purely electronically traded. When looking for the most liquid time of day to trade a Commodity Futures contract look to trade during the Open Outcry time also known as Regular Trading Hours (RTH).
Daily Price Limits:
Some Commodity Futures contracts, not all, have daily limits imposed by the exchanges. These are prices set the previous day for the maximum amount the market may rise or fall the next trading day. It is important to know if the market you are trading has these limits. Always know this information to avoid being caught in a Limit Move that can be devastating to your trading account.
This area tells you if the Commodity Futures contract calls for physical delivery or cash settlement. Physical delivery means you would have to deliver or take delivery of the Contract if held until expiration. Cash Settled means you would be responsible for paying any losses in cash at expiration or having cash deposited in your account if profitable.
Last Trading Day of Contract:
Your broker will typically let you know if you are near the expiration of a contract. As always, it is a good idea to know about this ahead of time. On this date the contract is retired and put in the history books.
Commodity Ticker Symbol:
Exchanges create a root symbol for each Commodity traded much like a Stock will have a symbol (CSCO, ADM etc.). Many Commodities now have different symbols for the same Commodity. This is to help identify if the Commodity is pit traded or electronically traded.
Since a Commodity Futures contact is simply an agreement between a buyer and a seller you will never run out of Futures contracts. As long as there is a buyer and a seller there can be a contract created. Unlike Equities where each company only floats a fixed amount of shares that are tradable.
Commodities are truly Supply/Demand driven. As long as we have an ever increasing world population and developing countries there will be Demand for Commodities. This Demand is infinite compared to only a finite amount of Supply for each Commodity. Perhaps this will result in another bull market run in Commodity prices.
As many traders begin in the Futures markets, I feel it is important for each trader to understand any Futures contract they are trading. Be aware of early closing days around holidays, limit moves, physical delivery or cash settled and of course how much capital is required to trade the market (margin).
“If it is important enough to you, you will find a way. If it is not, you will find an excuse”
– Don Dawson