Commodity Futures and How They Work

Commodity Futures and How They Work

Today, residents of South Africa and Nigeria have access to a wide range of financial tools. International brokers are tailoring their services to local needs. Aside from Forex, there are more complex options. Futures contracts are risky instruments that are associated with high potential profits. Here is how they work. 

Any commodities (crude oil, wheat, precious metals, etc.) may be bought and sold via futures. These are special legal agreements. As the term suggests, their subject is future transactions. The buyer agrees to purchase the commodity and receive physical delivery at a predetermined price and time (contract expiry). The other party agrees to sell and deliver the commodity when the contract expires. 

Benefiting from Futures: Notable Examples

Commodities are bought and sold by speculators and institutional/commercial users. A manufacturer may use futures to optimize expenses. When production relies on a certain commodity, it is common to take a position in the futures market. This allows manufacturers to reduce their risks in case the price for their raw material changes. Here are a few other examples.

  1. The Airline Industry 

Air fleets require gigantic amounts of jet fuel. These must be purchased at predictable prices. In this regard, futures offer a hedging opportunity. They allow airlines to stay within budget, purchasing fuel at fixed prices. Companies thereby are less affected by unfavorable trends in the oil market.

  1. The Farming Sector 

If cooperatives were unable to limit their risks, they would be more likely to go under. After all, commodity prices may be extremely volatile at times. Predictable value is key to the successful management of operating expenses.

  1. Speculators

These investors also partake in the exchange. Such players buy agreements and hold them for shorter periods of time. Their goal is to profit from changes in prices for the underlying asset. This is the nature of speculation in general. 

Short-term traders are not interested in the physical delivery of commodities. All they do is buy and sell futures contracts only. They close their positions before the contracts expire, so no delivery occurs.

How to Trade Futures

Access to this market is more complicated than entry to the global currency exchange. Unless your broker firm deals with futures, you need to open a new brokerage account. Learn more about commodity trading in Africa and see if it is suitable for you. Like any form of investment, the exchange of futures has inherent dangers. This is why investors are asked to confirm their acknowledgment of the associated risks.

As regards the minimum deposit, its size depends on the broker. In addition, the value of your account will rise or fall with the value of the futures contract. If the latter loses value, a margin call may be received. This means you will be obliged to deposit more if you want the position to remain open. Alpari provides expert guidance on the subject.

Like other financial tools, futures contracts are traded on leverage. This means you may open a position for more than your deposited funds. The broker provides a portion of its capital in order to boost your purchasing power. As a result, minor shifts in prices could bring substantial gains or losses. Sometimes, an account may be doubled or emptied in minutes.

Advantages of Futures

This financial instrument has four key benefits. First, it is easier to analyze the market, as everything relies on the underlying commodity (e.g., crude oil). Secondly, the profit potential is impressive. Thirdly, it is possible to control full-size contracts even with a minimum-deposit account. Last but not least, both long and short positions can be taken.

Disadvantages of Futures

Naturally, due to potential high volatility, risks cannot be denied. This is why newbie traders are advised against investing in futures. Due to leverage, risks are magnified along with potential profits. If the market experiences a sudden downturn, one may lose their deposit or even more. Unless you close your position quickly, consequences may be dire. 

Ways to Lower Risks

The high-risk nature of futures makes them daunting. Luckily, most contracts give investors the opportunity to buy options. The latter offers a safer entrance to the futures market. The scheme may be compared to making a deposit on an item instead of buying it immediately. An option makes you entitled – but not obliged – to complete the transaction when the contract expires. If the market moves against you, losses are limited to the amount paid for the option.