Trading with commodity futures requires specifying in detail the exact nature of the agreement between the buyer and the seller in order to make sure that the two parties will meet the contract. The largest exchanges on which futures contracts are traded are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). Commodity futures include pork, bellies, live cattle, sugar, wool, lumber, copper, aluminium, gold and tin.

When developing a new commodity futures contract, the exchange must specify in detail the asset, the contract size, where delivery will be made and when delivery will be made. Sometimes alternatives are specified for the grade of the asset that will be delivered or for the delivery locations. As a general rule, the party with the short position (the seller of the commodity) will choose what will happen when alternatives are specified by the exchange. Particularly, for commodity assets, there may be quality variations of what is offered in the marketplace. Therefore, when the asset is specified it is essential that the exchange stipulates the acceptable grade or grades of the commodities.

The contract size specifies the amount of the asset that has to be delivered under one contract. If the contract size is too large, investors with small exposure cannot hedge or speculate through the exchange. In the contract size is too small, investors engage in expensive trading as there is a cost associated with each contract traded.

Delivery arrangements are also specified by the exchange. This is particularly important for commodities that involve high transportation costs, which affect the delivery place. Also, a futures contract is referred to by its delivery month. The exchange must specify the precise period during the month when delivery can be made. Typically, the majority of futures contracts are not delivered because most traders choose to enter into the opposite type of trade that the original one (close out their positions) prior to delivery period specified in the contract.

For most commodity futures contracts, daily price movement limits are specified by the exchange. A limit move is a move in either direction equal to the daily price limit. If the price moves down by an amount equal to the daily price limit, the contract is said to be limit down. If the price moves up by the limit, it is said to be limit up. Typically, trading ceases for the day once the contract is limit up or limit down.

Price limits and positions limits aim to prevent large price movements deriving from excessive speculation. However, they can also become an artificial barrier to trading when the price of the underlying commodity is increasing or decreasing swiftly.

To illustrate how commodity futures are settled, let’s suppose that John believes the domestic fall production of oats has been under estimated in mid-summer, while Peter thinks the domestic fall production of corn has been over estimated in mid-summer. Using the commodity exchange as a market place, since John believes corn prices will decline, he sells a futures contract, and Peter buys a futures contract because he believes the price is going to increase. Assume that John and Peter sell and buy their contracts for the same price and they are held by each other, and in three months, John must buy back his contract and Peter must sell back his contract. By both individuals ending up with no obligations, this clears the market and there is no credit risk involved as cash flows are spread until the underlying commodity reached maturity. Furthermore, the contract price is allowed to freely change in value during the three months depending on the change in supply and demand for the underlying commodity.

Now, depending on what happens to prices during the following months, the contract will remain unchanged in value, appreciate, or depreciate: (1) if the value doesn’t change, neither person benefits, (2) if the value appreciates, Peter would earn a profit by selling back his contract at the new higher price and John would lose money by buying back his contract back at the new higher price, and (3) if the value depreciates, Peter would lose money by selling back his contract at the new lower price and John would profit by buying back his contract at the new lower price.

Overall, trading with commodity futures is a good way to make money, but there are also pitfalls involved. Commodity markets are highly volatile and are likely to remain volatile mainly because of geopolitical concerns, contracted demand-supply fundamentals, growth and inflation pressures and many other factors that put pressure on the global commodity market. On the other hand, in majority, commodity markets are broad and liquid and transactions can be completed quickly. This eliminates the risk of adverse market moves, which can be made between the time of the decision to trade and the trade’s execution.

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