Commodity futures contracts allow you to directly purchase a wide variety of commodities. Commodities include corn, wheat, soybeans, gold, silver, crude oil, cocoa and coffee, but there are many others. But why are these contracts called futures?
They’re called futures because when you buy and sell these commodities, they are not to be delivered until a specified future date. When you buy or sell a futures contract, all you have to do is put down a good faith deposit, similar to the way you would when you open escrow on the purchase of a new home.
Is a Futures Contract an Option?
An option contract is the right (not the obligation) to buy something at a future date, but a futures contract is an obligation to purchase or sell something at a future date. Therefore, a futures contract is not an option.
For example, when you buy a corn futures contract, you have bought that commodity (i.e., an entire 5,000 bushels of corn). However, you don’t have to pay for it until the date of delivery. The only thing you have to pay for upfront is the good faith deposit.
In more formal terms, a commodity futures contract is simply a contract between a buyer and seller — one agreeing to purchase a specified quantity of a commodity on a future date, the other agreeing to deliver at a price worked out today.
Where Will I Put All Those Pork Bellies?
Of course, few commodity traders want a truckload of soybeans or pork bellies dumped on their front lawn, nor do they plan to dump them on someone else’s lawn. What usually happens is that most futures positions are closed out before the deliver date.
Because they seldom make or take delivery, commodity futures traders are only required to deposit a portion of the contract’s value. This is called the “initial margin,” and it’s the equivalent of that good faith deposit mentioned earlier.
The minimum initial margin for each futures contract is set by the commodity exchanges, but brokerage firms usually require traders to deposit more than just the minimum required by the exchange. Typically, margin is between 2% and 10% of the contract value. Volatile futures contracts require larger deposits than less-volatile ones, and either the exchange or your broker can change the margin requirements at any time.
Futures and Margin
When the price of a contract changes, you may find yourself with too much or too little margin deposit. If the price rises, traders with short positions must increase their deposits. If the price falls, traders with long positions must add to their accounts. In both cases, traders will receive a “margin call” from their broker ordering them to deposit enough money to bring their account balance back to a “maintenance” level. If they do not respond immediately, a broker will liquidate their position.
When you buy options on a futures contract, there are no margin requirements. Like stock or index options, you can’t lose more than your initial investment. However, if you write options on futures or if you implement any kind of spread strategies, you may be subject to margin restrictions.
Spot vs. Futures Prices
If you wanted to go out today and buy 5,000 ounces of silver, you would purchase it in what’s called the spot market. But with a futures contract, you won’t pay for the silver for months, or even years. You do, however, profit or lose just as if you owned 5,000 ounces of silver.
Because owners of silver, who would be the sellers of futures contracts, must pay for insurance, interest and storage (all referred to as “carrying costs”), the prices of futures contracts is usually higher than the spot price. The difference between these two prices is called the “basis.” The basis for more distant futures contracts is usually wider than for near-term ones.
NEXT >> What’s Up With That?