Commodity futures are contracts that are traded on commodity exchanges. The prevailing concept of a commodity futures contract is that it affords traders of commodities a certain degree of security and confidence in transactions. This need for security largely stems out of the volatile nature of the market and ever changing commodity prices. In order to protect against potential loss through a decrease in price, and to allow for increased gain through price speculation, traders use futures contracts.
These contracts are agreements to deliver a set amount of a commodity at a set time and for a set price established at the time of trade. For example, a trader may agree to sell an amount of coffee for a fixed price in 6 months time. If, during that time, the market price of coffee has decreased, the seller has protected himself by predetermining a price at the time of trade before the slump in the market. This can also work the other way: if the market price of coffee increases in the interim, then the buyer is presented with the ability to buy the coffee for the original lower price, and make a profit by selling it on for the later higher price. Speculating on the commodity futures can therefore be an extremely profitable or extremely damaging enterprise, depending on one’s skill in predicting market trends.
This has the effect of producing two types of buyers in the commodities market: those who merely speculate on the market to make a profit and those who are buying commodities for actual future use. As commodity trading speculators have no genuine need for the commodity other than as a route to making profit, the futures contracts are often liquidated if the price of the commodity on the market drops below an acceptable level or if the price rises sufficiently to allow for a profitable transaction. At some point before the due delivery date, both the buyer and the seller of a particular contract will often make an offsetting purchase or sale. Sometimes, in order to obtain the volume or amount of the commodity needed to satisfy a futures contract, traders will employ a type of transaction known as a spot contract, which calls for the immediate delivery of that commodity.
Commodity futures contracts are sold on margin, meaning that only a fraction of the value of a commodity one is purchasing need be put up as collateral. These margins are set by the regulators of the exchanges, who set larger margins for commodities where the price fluctuates more wildly. As a result of this, it is both possible to enjoy great gains or suffer great losses when commodity futures trading. At particular risk of loss, for example, are farmers selling futures contracts on crops that have not yet been harvested. Uncontrollable and unpredictable factors such as the weather can either be a boon or a blight to farmers and those that speculate on their commodities. Staying well informed on the various factors that affect commodity prices helps to mitigate the possibility of potential loss when investing.