Months of “roller coaster ups and downs” in the crude oil commodities market have inspired many Americans to learn more about the volatile nature of the markets and the impact speculators can have on our daily lives.
Speculation for profit is an important aspect in commodities or futures trading. But in business, futures trading is a common form of risk management, which allows a producer to manage risks associated with producing a commodity today for sale in the future.
Trading in the futures markets can be used for both hedging and speculating.
The terms, commodities and futures, have become synonymous today and are often used interchangeably to discuss futures trading.
To be more accurate commodities are the physical goods traded such as corn, crude oil, gold and soybeans. Futures are contracts for commodities, often of standard quantities and quality, that are traded on a futures exchange such as the Chicago Board of Trade.
According to the U. S. Commodity Futures Trade Commission (CFTC), a futures contract is an agreement to buy or sell in the future a specific quantity of a commodity at a specific price. The commission is the federal agency that regulates futures trading.
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell a specified quantity of a commodity or other instrument at a specific price within a specified period of time, regardless of the market price of that instrument.
Most traders in the futures and option markets are commercial or industrial users of the commodities they trade. These users, most of whom are called “hedgers,” want the value of their assets to increase and want to limit, if possible, any loss in value due to a change in price. Speculators hope to profit from changes in the price of the futures or option contract.
Large speculators often pool their money together to reduce their risk. Small speculators may be individual traders, trading on their own accounts or who use the services of a commodities broker.
The driving forces in today’s commodities markets can be boiled down to the fundamentals of supply and demand versus the more technical forces derived from speculators’ activities.
“Speculation in the market can and often does drive the markets to extreme highs or lows,” said Scott Mueller, of Samson LLC in Platte Center. “But, regardless of how high or low the markets go, the market will always return to the fundamentals of supply and demand values.”
Agricultural commodities may offer the clearest example of why someone would deal trade futures contracts for the purpose of hedging or risk management.
Take for example a hypothetical wheat producer who wants to guarantee the price he will receive in the future for his recently planted grain at today’s price of $3.50 per bushel. The producer enters into a futures contract with a buyer, such as a bread manufacturer, who promises to purchase the wheat at a future date at today’s price of $3.50 per bushel. The hypothetical futures contract signed in May is for delivery of 30,000 bushels of wheat on December 1.
In this scenario, both parties are speculating that the daily price of wheat at the time of delivery could be a disadvantage to them.
The farmer speculates that the price may drop and the $3.50 per bushel could be an advantage to him in the future. The buyer in this case is speculating that the price will be higher and by agreeing to the current price, the manufacturer may profit from receiving the commodity at a lower price than it may sell for at the future date.
If the contract goes to actual delivery and wheat sells for $4 per bushel on Dec. 1, the farmer has lost money but is still guaranteed the $3.50 per bushel price. If on Dec. 1, the price has dropped below $3.50, the buyer takes a loss, but has mitigated the risk through the agreed price set in May.
In today’s markets, futures contracts have moved beyond the realm of agricultural commodities and now include the sale and trade of financial futures such as the S&P 500, T-notes, foreign currencies and others.
“It’s easy to get into the markets, but very important to have a game plan up front and especially with regard to a clearly planned-out exit strategy, so that emotions don’t get in the way of getting out when it’s time,” Mueller said. “If it’s someone’s first time in, it’s a good idea to work with someone who understands what you want to do. A person can start with virtually any amount of money, but a general principle is to determine that you won’t risk more than 10 percent of your starting capital on any specific trade.”
Educational materials on the U. S. Commodity Futures Trade Commission Web site warns beginners of the potential hazards of trading commodities. “Trading commodity futures and options is not for everyone,” the site states.
“It is a volatile, complex, and risky business. Before you invest any money in futures or options contracts, you should consider your financial experience, goals, and financial resources and know how much you can afford to lose above and beyond your initial payment; understand commodity futures and option contracts and your obligations in entering into those contracts; understand your exposure to risk and other aspects of trading by thoroughly reviewing the risk disclosure documents your broker is required to give you.”
For more information, visit the U. S. Commodity Futures Trade Commission’s education center at www.cftc.gov/educationcenter. Up-to-date information is also available online at www.samson-inc.com/markets.html.
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