What is Commodity Futures Trading?

Commodity futures trading is where investors and financial groups trade the rights to buy or sell a particular commodity for a set price on a set date in the future. If the holder of these rights, known as a contract, has guessed correctly, she will be able to exercise the right and make an almost immediate profit. For example, the contract may give her the right to buy 100 ounces of gold at $10 US Dollars (USD) an ounce. If, when the contract came due, gold was trading at $12 USD an ounce, she could buy the 100 ounces and immediately sell it. However, if gold was trading at $8 USD, she would not have to do anything and would simply write off the money they spent buying the contract.

The holders of futures contracts must constantly assess the risks they are taking and the potential rewards based on changing expectations of the trading price of the commodity on the contract's due date. They may decide to sell the contract to somebody else before its due date. Somebody who sells on a contract gives up the opportunity to make any money from buying or selling the commodity later on. However, he is no longer risking the money they spent on the contract and will either have made a guaranteed profit or at least limited their losses to a particular amount.

Unlike other types of future trading, commodity futures trading specifically deals with tangible goods. The most common types of commodity involved are foodstuffs and metals, though futures contracts can involve any commodity for which there is a market. Other types of futures trading deal can involve assets such as company stocks, or may relate to the overall value of a particular market.

It has been said that commodity futures trading is far from an original idea. One ancient Greek story involved a man guaranteeing a fixed price with olive press owners to use their equipment the following summer. When the harvest was, as he'd predicted, particularly good, he was able to sell his slot with the presses to other olive growers at a profit. The only major difference between that story and today's futures trading is that now the right to the slot might change hands several times before the harvest.

The future contract used in commodity futures trading is different from another type of financial instrument which is known as a forward contract. Unlike a future contract, a forward contract is a binding agreement on both parties that means the buyer must pay the set price on the set date rather than merely having the option. A forward contract is more risky for the buyer and this makes it more difficult to trade the contract before it comes due. However, the forward contract is useful for the commodity manufacturer as it means they can know far in advance how much they will receive. While this may sometimes mean they wind up getting less than they would without the contract, it helps eliminate risks and unpredictability and allow better cashflow forecasts.