Commodity futures trading involves the exchange of cash payments for contracts. These contracts are agreements to deliver certain commodities at a predetermined price, despite any fluctuations in price that may occur in the mean time. Commodity futures trading differs from standard commodity trading by the expected time of delivery: whereas standard commodity trading (or spot trading) involves an immediate delivery after the cash payment, futures trading only offers a contract for a scheduled delivery sometime in the future.
The two types of commodity trading also differ in terms of payment. Payments in spot markets are generally paid at once and in full in return for the full amount of commodities ordered. In commodity futures trading, however, one must often only pay a percentage of the full price, the ‘margin’, until the commodities are ready for delivery. This has important implications for commodity futures brokers for it means that they can command a large amount of a certain commodity without fully paying for it. Especially if they plan on selling the contract before delivery this can increase the commodity brokers‘ margin.
This type of commodity trading has its roots in the 1800s agricultural market where prices for a farmers’ harvest were agreed upon months before the wheat or corn could be delivered. This protected the farmer from severe fluctuations in price depending on weather or new trade agreements and it also protected the buyer from large increases in the price of any of these agricultural commodities. Perhaps more importantly, however, futures trading also offered the buyer the opportunity to make a hefty profit. If a hundred bushels of wheat were bought at a low set price, for example, and a drought occurred, increasing the rarity and consequently the price of wheat, the buyer would still have a right to his or her hundred bushels at a price that was now extremely low. The buyer could then sell his newly acquired wheat on at twice the price paid, allowing a generous profit margin.
Thus, prices on the commodity futures market is highly influenced by the supply and demand of the chosen commodities. A commodity trader looking to make a profit through his or her investments will therefore seek to predict the trends of the market and purchase contracts according to that speculation. However, commodity futures brokers now will have little to no intention of receiving the actual commodities that they own contracts for. Instead, they will seek to sell these contracts on to others at the height of their value. Thus, some traders will hold these contracts for no longer than a day, seeking to make small quick profits from short-term trends. In this way, commodity futures trading is almost completely separated from the commodities themselves. Commodity futures trading remains the more risky form of commodity trading, where both the biggest profits and the biggest losses are made.