How To Understand the Commodity Futures Markets

Commodity Futures 101

This article will cover the basics of understanding the commodities market - to get more detailed information, it's a good idea to enroll in some online finance courses. Commodity futures contract trading is both highly profitable and extremely risky because of leverage. Leverage is the ability to control a large quantity of a commodity for a very modest investment. That investment is called margin. We will discuss the role and function of margin in another step.

First, we will go through the basic components of commodity futures markets and trading, then we will bring it all together with an example of the lifecycle of a commodity futures contract.

Step 1

Below is a list of Futures Industry terms that will help you understand this commodity futures market tutorial.

  • CFTC – Similar to the SEC for securities markets. The CFTC is the regulatory body responsible for oversight of domestic commodity futures trading and exchanges.
  • Hedger – The hedger is a user or a producer of a specific commodity that participates in the futures markets as a hedge or insurance policy to lock in prices for future sales or purchases of the underlying commodity. Here is a detailed explanation of commodity hedging.
  • FCM – FCM is the acronym for Futures Commission Merchant. The FCM is also known as a brokerage house. The FCM collects commissions from its customers for taking and executing orders on the trading floor or through an electronic trading platform. Only FCM’s that are clearing members can pass trades that have been executed to the clearing house.
  • Marked to Market – The monetary value (open trade equity) of open positions which is calculated by comparing the individual trade prices to the daily end of day settlement prices posted by the exchanges.
  • Open Interest – Open interest is the total number of un-liquidated or outstanding long or short futures contracts in any given commodity at a given time. A detailed open interest report breaks down the open interest by commodity and month. Since over 99% of all futures contracts are offset prior to delivery, increases in open interest can increase the contract’s liquidity.
  • Open Outcry – Open outcry is the verbal exchange of bids and offers at a designated location and daily timeframe. Open outcry is the most common method of floor trading on the world’s stock and commodity futures exchanges. On commodity exchanges, the trading ring is called “the pit.”
  • Open Trade Equity – Open trade equity is the marked to market value of the open commodity futures positions in a trading account and is expressed as a gain or a loss.
  • Speculator – The commodity futures speculator participates in the trading of commodity futures contracts solely to make a profit. Without the speculator, the futures markets would have very little liquidity or fail to exist at all.
  • Total Equity – Total equity is the sum of a trading account’s positive or negative cash balance and the gain or loss on the account’s open contract positions in the futures markets.

Step 2

What is an exchange traded commodity futures contract? A commodity futures contract if held to the expiration date is a binding agreement (trade) between a buyer and a seller to buy (take delivery) or sell (make delivery) of a specific amount of a specific grade of a commodity at a specific price on a future date.

Just about anything commonly produced, grown, raised, mined, manufactured or readily available that can be bought or sold is a commodity. But very few commodities end up being exchange traded commodity futures contracts.

Each contract has a standard size, trading months, expiration day, deliverable grade, and delivery location. These standards are set by the exchange where the contracts are traded.

Unlike stocks which have a set number of outstanding shares available in the marketplace, commodity contracts have a floating volume known as open interest, which fluctuates with the creation or liquidation of open commodity contracts. All commodity futures contracts are traded on margin.

Step 3

What is a commodity futures exchange? As an entity, a commodity futures exchange is a designated location where listed commodity futures and option contracts are traded (executed) in accordance with guidelines set forth by the exchange and governed by the CFTC. Trades that are done using auction-style open outcry are executed on the floor of the exchange in the “trading pits.”

Trades executed electronically are executed using PC-based trading platform. Buyers and sellers trades are matched up electronically via the trading system. After the point of trade, the position lifecycle mirrors that of an open outcry trade until the position is liquidated electronically.

Due to consolidation in the Futures Industry, there are only two major domestic commodity futures exchanges left in the U.S. They are the Chicago Mercantile Exchange and its subsidiaries; the Chicago Board of Trade (CBOT) and the New York Mercantile Exchange (NYMEX) and ICE Futures US (formally known as the New York Board of Trade NYBOT). Both exchanges have dual trading using both floor traded open outcry and electronic trading platforms.

Step 4

What is the economic role of the commodity futures markets? They are used as an insurance policy against price fluctuation. This is done by users and producers of the underlying commodity (hedgers) by hedging positions in the commodity futures market.

The hedger takes positions either long (as a buy), or short (as a sale), in the number of contracts that equals the quantity of their anticipated future sale or purchase of the underlying cash commodity.

Futures contracts are also used for risk management and as a tool for price discovery. Often, the most accurate pricing data is the contract prices that are traded on the Exchanges. In very liquid markets, the commodity futures markets can also act as price stabilizers.

Step 5

What affects commodity futures prices? In free market economies, supply and demand is the primary enabler for price movement. Any outside forces that affect supply and demand eventually affect prices.

Politics, economics, war, weather, acts of God and disasters can all affect supply and demand. Any combination of data related to changes in supply and demand is used by speculators to predict future trends in price movement. Since the hedger uses the futures markets to lock-in or protect prices, establishing their positions as a mirror image to a future purchase or sale, they are less concerned with supply and demand forces.

Step 6

What is commodity futures margin? Margin is an earnest deposit required for positions taken in the commodity futures markets. The margin deposit ensures there will be adequate funding for the initial number of contracts traded and proper financial maintenance of the futures contract until it is liquidated.

In other words, margin deposits ensure market participants meet their financial obligations while maintaining an open position. Margin requirements are set by the futures exchanges and are typically between 2 and 15 percent of the value of the underlying commodity contract. The amount varies from commodity to commodity.

Unlike stock margin requirements, which are set by the Federal Reserve, commodity futures margins are set by the individual exchanges where the contracts are traded.

There are basically two types of margin requirements: initial or original margin and maintenance or variation margin. The initial or original margin requirement is the exchange mandated per contract deposit required to establish a position in a particular futures contract market.

The exchange sets the amount, which varies, based on the commodity and the underlying market volatility. When a new position is established, the trader is issued an “initial margin call” for the amount required to establish the position.

The maintenance or variation margin requirement is an amount that is less than or equal to the original margin. The difference between the initial margin requirement and the variation margin requirement is considered a passive zone where funds are neither collected nor paid out. The maintenance margin amount is also set by the commodity exchange.

Once the total equity in an account drops below the maintenance margin requirement, a maintenance margin call is issued in the amount equal to the difference between the total equity and the initial margin requirement. The margin call brings the account back to 100% of the initial margin requirement. Below is a simple margin call example:

Initial: 5000

Maintenance: 4000

Total Equity: 2000

Margin Call: 3000

Since the total equity is below the maintenance margin requirement, the account is issued a maintenance margin call of 3000. The calculation is 5000 – 2000 = 3000.

Here is detailed explanation of commodity futures margin.

Step 7

How are margin calls satisfied? There are various types of collateral that can be deposited in a margin account. The type of funds allowed varies from FCM to FCM, but generally, cash, some forms of Government securities like T-Bills, letters of credit and warehouse receipts are acceptable.

An initial margin call can be satisfied by liquidating a previously paid for futures trade or with any of the acceptable forms of collateral mentioned above, but maintenance margin calls cannot.

Maintenance margin calls can only be met by cash deposits, sales of government securities or liquidation of previously paid for positions. T-Bills, letters of credit and warehouse receipts are not acceptable because maintenance margin calls are the result of market action. If a trader is losing money on a position, they can’t give the person on the other side of the trade a T-Bill, so cash is king when it comes to maintenance margin calls.

Step 8

What is a clearing house and what do they do? The clearing house is a totally separate entity from the exchange with which it is associated. The easiest description for the role of the clearing house is that they act as the buyer to every seller and the seller to every buyer.

In addition, the clearing house acts directly with the member clearing firms known as FCM’s and its associated exchange on a daily basis to settle trades; collect, maintain and disburse margin funds; oversee the delivery process; and report trade data to the exchange as well as the CFTC.

Step 9

Say what? Understanding how you can sell something you don’t own. Like other types of investments, commodity traders can make money whether they hold a long (buy) position or a short (sell) position. But unlike stocks, which require ownership of the underlying stock, futures contract sellers are treated the same as buyers in that the margin requirement is the same regardless of whether the trader buys or sells.

When a trader takes a long (buy) position, they hope the market price increases and allows them to make a profit on the price appreciation.

When the traders takes a short (sell) position, they are anticipating a drop in the market price of the commodity. This would generate a profit via buying the contract back at a lower price than they originally sold it.

In other words, as long as the sell price is higher than the buy price, both the buyer or the seller can make a profit. It all depends on what the price in the market did after the trade was executed.

Step 10

What is the delivery process? With the exception of cash settled futures contracts like the S&P 500 Index, physical futures contracts like coffee and gold are settled with the delivery of the underlying commodity if the futures contract is not liquidated before the contract expires. Over 99% of futures contract buyers or sellers never go through the delivery process by making or taking delivery of the underlying commodity.

These contracts are liquidated (offset) before the expiration of the contract. In other words, the buyer liquidates his contract by selling and the seller liquidates their position through a buy of the same contract and month. The term for this is referred to as “flat” or having no position (exposure) in that market.

Since a futures contract is a binding agreement to deliver or receive the underlying commodity, all contracts that are not liquidated must go through the delivery process. Though delivery procedures can vary from commodity to commodity and exchange to exchange, some aspects are consistent.

First, the buyers and sellers never actually arrange or make delivery of the commodity. The role of deliverer and receiver is taken by the clearing member (FCM). The FCM acts as a middleman between the exchange and the FCM’s customer.

The exchange on the other hand is responsible for assuring the proper grade, quantity, sanctioned delivery location and the proper adherence by all parties to the delivery procedure. The exchange also sets forth the proper time frames for each step in the delivery process.

The lifecycle of a commodity futures contract:

  1. The trader enters an order to buy or sell a specific contract.
  2. The trade is executed on the floor of the exchange by open outcry or electronically on a computer-based trading platform.
  3. The Exchange Clearing House collects the required margin from the FCM, which subsequently collects a higher amount from the trader via an initial margin call.
  4. The trade is now part of the trader’s open position. The Exchange increases the open interest (outstanding open commodity contracts in the market for that commodity).
  5. The trade is then offset or liquidated.
  6. The FCM’s margin obligation is released by the Clearing House and the margin money deposited is returned to the FCM. There is a corresponding release of the margin obligation of the trader.
  7. The resulting capital gain on the trade is paid out to the customer, while loses are deducted from the margin deposit cash on hand. In the case of an account deficit where the losses exceed the margin funds deposited, the FCM collects the difference from the trader in the form of a margin call.
  8. The exchange adjusts the open interest (outstanding open commodity contracts in the market) to reflect the futures contract lifecycle.

This process is completed hundreds of thousands of times per day.  If you want to learn more about the commodities market, it's a good idea to take some online courses in finance.

Rick Contrata has been in commodity futures operations management for over 25 years and is a former Series 3 registered commodity broker.

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Great article on the commodity futures market! Very detailed, and a great starting point for those looking to invest in or trade commodity futures.

By Travis Engebretsen

Have been trying to understand this for years. Thanks for detailing the key points here.

By Mary Norton