What are commodity futures and how do they work?

A commodity futures contract is a type of derivative whereby investors enter into an agreement to buy or sell a fixed amount of a commodity at a predetermined price on a predetermined date. Commodities can broadly be categorised as food, energy and metals. Within these categories, a contract will specify the underlying commodity, such as crude oil or corn.

The price of the futures contract is mainly based on the spot price of the underlying, but time until delivery, interest rates and storage costs are all determinants in the price. Buyers and sellers in the futures market have opposing beliefs about how the underlying commodity prices will realise. A buyer will make a gross profit in the event that the value of the underlying commodity has increased at the futures’ expiration and a gross loss if it decreased. On the other hand, a seller will make a gross profit when the value of the underlying decreases at the expiration and a gross loss if it has increased.

How do commodity futures work?

In contrast to other products such as stocks, with futures, investors do not pay the full cash amount upfront or own the underlying asset. Instead, they have to deposit initial margin to enter into the futures position. The amount of margin required is a percentage of the contract value.

Moreover, to find the value of a commodity futures contract (notional value), you multiply the price of the underlying and the contract size. The contract size is the deliverable number of underlying units represented in each contract. For example, a gold future can represent 100 troy ounces of gold.

Since only a percentage of the contract’s value needs to be put up initially, commodity futures are highly leveraged instruments. This means that slight price movements can have a large impact. When the margin requirement is higher, an investor typically needs to deposit more margin to enter the future position. This, in turn, results in lower leverage.

Futures contracts have a minimum price increment to which a particular contract can fluctuate, known as the tick size. This is determined in the specifications of the contract set by the exchange. Tick value, on the other hand, is the actual monetary amount that is gained or lost per contract per tick move and is equal to the tick size multiplied by the contract size.

How and when are commodity futures settled?

A unique feature of futures is that they are settled daily. At the end of each trading day, the closing market price is determined by the exchange that the future trades on. This is known as the daily mark-to-market (MTM) price and it is the same for everyone. There are daily mark-to-market settlements until the expiry of the contract or the position is closed out.

The daily cash settlement is the difference between the close price of t-1 and t. Depending on the result, the contract holder’s account is either debited or credited. For example, if at the daily settlement there is an increase in the contract’s value, this will result in a credit to the long position holder’s account and a debit to the short position holder’s account.

Commodity futures are typically settled physically at expiration. This means that with a long position, you have the right to delivery of the underlying commodity. While it is common for commodity futures to be physically settled, it is also possible that they are cash-settled. ESKIMO does not facilitate the physical delivery of commodity futures. For that reason, you have to close your position before expiration. With a long position, you close the position by entering an opposing order to sell the number of contracts you have a position in. With a short position, you enter a buy order for the number of contracts you have a position in to close it.

Where can I find information about a commodity future?

Since commodity futures are standardised contracts that trade on an exchange, information about the contract can be found on the exchange’s website. One of the most commonly known commodity exchanges is COMEX, which is a subsidiary of CME Group. Other well-known derivative exchanges are CBOT, NYMEX, Eurex and Euronext Derivatives.

Specifications about a commodity future can be found on the relevant exchange’s website. This includes information such as the contract’s size, underlying commodity, maturity date and trading hours. Other information about the characteristics and risks of the product can be found in its Key Information Document (KID). On the ESKIMO platform, investors can find a product’s KID by clicking on its name and then selecting ‘Documents’.

Investing in commodity futures with ESKIMO

At ESKIMO, you can trade in futures on a number of affiliated derivatives exchanges. You can find all of the futures contracts we offer when you log into your account and select futures under the products tab.

What are the risks and rewards?

Trading futures on the commodities markets can have a high reward, but it also comes with substantial risk. When investing in commodity futures, you can lose more than your initial investment.

The price of the underlying commodity can sink lower than zero. Therefore, the potential maximum loss in a long position in a commodity future can exceed the contract value and is, in theory, unlimited. On the other hand, since the price of the underlying can theoretically rise without limits, the potential maximum loss in a short position is unlimited. It is recommended to only enter into obligations that you can meet with money that you do not need in the short term.

The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.