Introduction to Future Contract Commodities Trading

For those confused by commodities trading, lets look at a simplified future contract trade.

Imagine a trader buys a contract to purchase oil trading on NYMEX (The New York Mercantile Exchange) at $70 per barrel for WTI with an expiration date of August 6th. (Obviously oil comes from a variety of major sources, including the North Sea near England, Alaska, Saudi Arabia, West Texas, etc. The locations are often used as the names for different sub-types of commodity and often have different prices).

There are several things to note about this contract, called a future.

It names a specific commodity. It isn't a contract for North Sea Brent, it's for WTI (West Texas Intermediate) Crude. While oil as a whole is a commodity with similar properties, the actual material recovered varies from place to place. There are as many types and names as there are for cigars.

Prices between oil vary due to differences in cost of production, refining and shipping costs, inherent composition and many other factors, including expected demand.

It has a specified price: $70 per barrel. A portion of that money, called the margin, is to be paid today. Usually around 5%, the required margin amount changes depending on a number of factors, such as how volatile prices have been in the recent past.

Each contract specifies a set amount, usually 1,000 U.S. barrels (42,000 gallons, equivalent to roughly 168,000 liters). At 5% of $70 per barrel, a contract for a 1,000 barrels requires a minimum investment of $3.50 x 1,000 = $3,500.

For an investment of $3,500 the speculator is controlling $70,000 worth of oil. That's known as leverage.

The contract has an expiration date and along with this, an associated obligation for delivery. On or before August 6th the contract holder has to deliver 1,000 barrels of West Texas Intermediate Crude with specified characteristics. For example, exchanges determine such things as minimum acceptable levels of sulfur content.

Most traders don't have any real expectation of delivering it and are never going to see a drop of that oil. In fact, they don't have it to deliver. They are trading contracts for goods, not the goods themselves. The final contract is ultimately handled by a specialist broker who ensures delivery of the actual product to some 'consumer' like an oil refinery.

What is important is that the trader has to do something by a given date. That has interesting consequences, such as the change in price for the contract itself as the expiration date nears.

Unlike an options contract, a futures contract carries not only the right to buy or sell something at a given price by a specified date, but the obligation to do so.

If the spot price (the price of a barrel of oil at a given time, in a specific market) changes, the contract trading price will also change. How it changes, and by how much, we have to leave for later. But suppose the price for WTI rises to $75 per barrel before expiration.

How much profit, in percentage terms has the trader made?

$75 - $70 = $5 per barrel. $5 per barrel x 1,000 barrels = $5,000. $5,000 - $3,500 = $1,500 (excluding commissions). $1,500 / $3,500 x 100% = 42.86%.

In today’s market, that sort of profit is not out of the question. Anyone considering entering the commodities trading world needs to be aware of the fact that prices are extremely volatile. While high profits are possible, there is also a high risk level associated with this type of trading.

         

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