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Commodity Futures Trading Basics

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What Are Futures Contracts?

A futures contract is an obligation to buy or sell a commodity at or before a given date in the future, at a price agreed upon today. A transaction in the commodity futures market is made on the trading floor (or in the trading computers) of the exchange between brokers who are members of the exchange that particular commodity is trading on. The seller will have a broker, and buyer will have a broker.

There are speculators and hedgers that trade in the commodity markets. A hedger is not interested in making a profit off the movements in price of a commodity futures contract, but rather wants a guarantee to buy or sell at a cetain price. E.g. if crude oil is trading at $60 per barrel in the June contract, an oil drilling company could sell contracts at that price to lock in that price and it can still for $60 when the time comes, even if the price went down to $48 in the meantime.

Speculators will buy and sell futures, or options on futures, for the purpose of making a profit. They will buy futures (a long position) when they think prices will rise, or they will sell futures (a short position) when they think prices will fall. Both the speculators and hedgers add volume to a market making it a more liquid market to trade.

Commodity futures trading is a type of investment where one can make money by speculating on the price of a certain commodity going up or down in the future.

When talking about certain commodities being traded in the futures market, they must meet certain conditions. One of the conditions is that the commodity should be standardized. In trading agricultural and industrial commodities, the traded commodity should be in its basic raw and unprocessed state. In this case, wheat may be traded in the futures market but not flour.

The history behind futures trading in commodities evolved from the farmer’s need to earn more from every harvest. Before commodity futures trading started, the farmers were always at the mercy of the dealer when it came to pricing and selling their harvests. Dealers usually set the prices and the farmers could not to anything but accept the terms.

In the search for having a more fair system of doing business, farmers began offering future harvest to interested buyers. The farmers started giving their own terms for the future harvests to dealers. The transaction consisted of commodities offered as a certain price and to be delivered as a specified date. Contracts were then drawn up between the farmer and the interested buyer that specified the certain amount of commodity to be delivered at a particular time in the future. From this system, what is now known as futures trading has begun.

It was sometime in 1878 that a central dealing facility for such commodities contracts was established in Chicago. In this facility, farmers and dealers began initially in spot dealing of their grains that was immediately delivered upon a reached settlement in price. It eventually evolved into futures trading when farmers started committing future harvests to interested dealers willing to buy to ensure that their grains supply are maintained in the future.

In the beginning, futures trading initially consists only of a few farm commodities such as grains. But later on, a huge number of other commodities joined in. Now there are futures trading markets that deal in precious metals such as gold, silver and platinum. There is also a futures trading market for livestock and cattle as well as for energy products such as crude oil and natural gas. It has gone on to include futures trading in coffee, orange juice ad industrials such as lumber, cotton and even on interest rate bearing instruments such as currencies and stocks.

In recent times, more trading has been done through the use of online futures trading, eliminating the use of telephones and calling of brokers on the telephones. The futures trader can trade directly from their computer and have the trade routed directly to the trading floor of the exchange. At the exchange some orders (electronic markets) are executed immediately in the exchanges computers. This is becoming the more preferred method of trading because it tends to be quicker.

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