by Ken Trester | May 16, 2012 10:28 am
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.
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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.
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.
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.
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.
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Newcomers to the commodities markets usually don’t know what to make of the price discrepancies between identical futures contracts calling for delivery in different months. The reason is that the more distant futures contracts have higher prices than those calling for delivery this month or next.
It costs more to store copper, silver, cattle, orange juice, pork bellies or virtually any commodity. Costs include storage, insurance, interest, and in some cases, feed (as in the case of cattle futures). Here again we see the carrying charges, and these charges have a direct influence on futures prices.
Here’s an example to illustrate my point. Let’s say you’re a hog farmer who wants to sell some inventory soon. You can sell a futures contract calling for delivery in June or August. Unless the price of the August contract exceeds the price of June by an amount equal to the carrying charges, to compensate for feeding costs, etc., you would sell a June contract.
Long-term contracts usually sell for more than near-term futures, and the difference almost never exceeds the carrying charges. For example, if carrying charges are 2 cents per month, August hogs would sell for 4 cents more than June. But the price of the August contract cannot exceed the June price by more than 4 cents.
Let’s say the difference widened to 5 cents. What would happen?
A knowledgeable hog farmer would buy some hogs today and immediately sell an August futures contract for 5 cents more than his purchase price. Since it will only cost him 4 cents to bivouac and feed his hogs for two months (the carrying charges), he has guaranteed himself a 1-cent profit.
In an efficient market, large commercial hog farmers do the same thing, driving the price difference down if it widens to more than the carrying charges.
Commodity options control futures contracts; and futures contracts, in turn, control physical commodities. With options, however, your risk is much less than with futures, which is why many people prefer them. But how much do you make if a futures contract rises above a call option’s strike price?
Commodity options are different than stock options. With stock options each contract controls 100 shares of stock. Of all commodity futures options, only the 100-ounce gold contract is the same as stock options. Many commodity futures contracts, including those on cattle, hogs, copper and coffee, are priced in cents per pound. The value of a 1-cent move in a given contract differs from commodity to commodity, because each contract is for a different size or quantity of the underlying commodity.
For example, a coffee contract covers 37,500 pounds, making a one-cent move worth $375, while a copper contract covers 25,000 pounds, so a penny move is worth $250. Wheat, corn, oats and soybeans are priced in cents per bushel, usually with a 5,000-bushel contract, so each 1-cent move equals $50.
As you can see, there’s a lot to learn when dealing with options on commodity futures. Once you learn the terms of contracts and what factors drive specific markets, you’ll discover why many people find trading options on commodity futures an excellent way to make big profits.
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