As we all are aware, a futures contract is an agreement between two parties to trade a particular asset at a fixed price on a fixed date in future.
Commodity futures are those future contracts which have the underlying asset as a Commodity.
So both these Commodity traders have opposing outlook on the same Commodity (Gold) but for the same time period and they decide to go for a futures contract on this Gold Commodity as an underlying. Futures Price - Say they both agree to trade this for $102 - this becomes the futures price.
Sunny will now benefit, because he will get $101 from Bunny for a Commodity that is currently trading at $90 only. Also note that if this is an exchange traded Commodity future, then there can be margin requirements as well as daily settlement of margins. In case this Commodity future trade is over the counter or OTC, then margin money requirements may not apply on daily basis, based on the mutual agreement.
In case of any futures contract defined on any underlying, the price of the underlying usually decides the price of its futures.
In case of Commodity futures, the price of the underlying Commodity will be the major factor in determining the Commodity futures prices.
Other than that, the interest rate, risk premium, time to expiry and cost of carry are other factors which may have an influence on price of Commodity futures.
The simple difference between a forward and a future contract is that forward contract is NOT through an exchange while future usually is on an exchange.
Most trader’s early introduction to futures probably came from the unlikely source of Eddie Murphy in the film ‘Trading Places’.
Whilst it might be tempting to think that futures trading is a recent invention, futures trading actually predates organised equities trading.
The first organized grain futures trading in the United States began in places such as New York City and Buffalo, but the emergence of what we would recognize as a modern futures contract occurred in Chicago in the 1840s. As trading of forward contracts (early individualized futures contracts) increased, the Board began the process of standardizing contracts – a move that would streamline the trading and delivery processes.
Until twenty years ago, futures markets consisted of only a few agricultural products, however as markets have matured, these agricultural commodities have been joined by an array of additional products.
All futures contracts are standardised in terms of the quantity, quality and delivery month. Financial futures also enable traders to take a position that replicates the underlying index without having to purchase all the shares in the index in their correct weightings. Register here for your FREE Trading Plan Template and it will be emailed to you straight away! Usually, spot prices from any spot exchanges are used as underlying benchmark for commodity futures. OR, he may have purchased Gold long time back at cheap price (say $50), but instead of selling them at market price of $110, he is forced to sell it to Bunny at $101 (the agreed futures price). Margin requirements on futures means both the parties assessing their positions at the end of each day and the loosing party providing margin money via the exchange to the winning party. Since futures are a form of forward delivery or promissory note, primary producers have been using them in one form or another for several hundred years. Instead of specific individual contracts which were inefficient and time consuming, traders were asked to deal contracts that were identical in terms of quantity, quality, delivery month and terms. For example the table below shows the contract specifications for the SFE SPI 200 Index Futures Contract.
Let’s assume that we are bullish the index and it is currently trading at 6300 points, so we purchase a single contract at 6300 points. When you buy the SPI contract by definition you are holding a surrogate portfolio that represents all the underlying shares in the index.
These futures can be exchange traded futures like those on Chicago Board of Trade (CME Group) CBOT, Chicago Mercantile Exchange CME or New York Mercantile Exchange NYMEX or can be OTC (Over the counter) between two parties on mutually agreed terms.
Like any other futures contract, Commodity futures have an expiry date and the futures price.
If at that end of the day, Bunny is in profit and Sunny is in loss, then Sunny needs to provide margin money to Bunny (via the exchange) to remain in the futures position). Japanese rice producers had a type of futures contract several hundred years ago to smooth out fluctuations in the prices they received for their crops.
Thus Chicago was a natural Mecca for traders, but the trading that took place there was inefficient and disorganised until a group of Chicago-based businessmen formed the Board of Trade of the City of Chicago in 1848. It is these features of standardisation that allows futures markets to function as effective hedging instruments. Some time in the future the index has moved to 6400 points and we close out our contract – our profit on the trade is 100 points multiplied by $25 per point or $2,500. The Board was a member-owned organization that offered a centralized location for cash trading of a variety of goods as well as trading of forward contracts.
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