Definition
A commodity futures contract is a legally binding agreement to buy or sell a specified quantity of a commodity at a predetermined price on a specified future date. Common underlying commodities include energy products, metals, agricultural goods, and livestock. Futures are standardized and traded on regulated exchanges.
Key terms (defined on first use)
– Futures contract: a standardized, exchange-traded agreement to transact a commodity at a future date and price.
– Forward contract: a privately negotiated (over‑the‑counter, OTC) agreement with customizable terms.
– Option: a contract that gives the buyer a right—but not an obligation—to buy or sell an asset.
– Margin: the initial cash (or collateral) deposited to open a futures position; a fraction of the notional contract value.
– Leverage: using a relatively small margin to control a much larger notional exposure.
– Cash‑settled: the contract is closed by exchanging the net cash difference rather than physical delivery.
– Delivery: physical transfer of the underlying commodity to a specified location when a contract is exercised at expiration.
How commodity futures work (mechanics)
– Standardization: Exchanges set contract size, quality specifications, delivery months, and delivery locations.
– Opening a position: Traders buy (go long) if they expect prices to rise or sell (go short) if they expect prices to fall.
– Margin and mark‑to‑market: Only a portion of the contract value is posted as margin. Gains and losses are calculated daily and credited or debited to the margin account. If losses erode margin below required levels, the broker issues a margin call requiring additional funds.
– Closing or settlement: Most contracts are closed before expiry by entering an offsetting trade; the difference between entry and exit prices is cash‑settled. Some contracts permit or require physical delivery at expiration.
Why futures differ from forwards and options
– Futures vs forwards: Futures are traded on exchanges and standardized; forwards are OTC and bespoke.
– Futures vs options: A futures holder has a legal obligation at expiry (unless closed); an option holder has a right but not an obligation.
Primary uses
– Speculation: Traders take directional positions to profit from price moves. Because futures are leveraged, small price changes can produce large percentage gains or losses.
– Hedging: Producers, consumers, and processors use futures to lock in prices and reduce exposure to adverse commodity price movements (e.g., a farmer locking a crop sale price or a manufacturer fixing an input cost).
Major risks
– Leverage risk: Small adverse moves can produce outsized losses relative to initial margin.
– Margin calls and forced liquidation: Large losses can trigger demands for more capital; failure to meet calls can result in position closure.
– Delivery obligations: If a position is not closed before expiry, the holder may be required to accept or make physical delivery of the commodity.
– Opportunity cost / over‑hedging: Hedging eliminates downside risk but also removes potential upside; over‑hedging can force costly unwinds if needs were misestimated.
– Market volatility: Commodity prices can swing widely, increasing both profit potential and the risk of large losses.
Short checklist before trading or hedging commodity futures
– Confirm contract specifications: contract size, tick value, expiration months, quality/delivery terms.
– Verify exchange and clearinghouse rules.
– Determine margin requirements and available leverage.
– Know settlement method: cash versus physical delivery and delivery locations.
– Plan an exit strategy: price targets, stop losses, and how to roll positions if needed.
– Check broker permissions: margin approvals and account limits.
– Consider tax and accounting implications; consult a tax professional.
– Stress‑test worst‑case scenarios to ensure adequate capital.
Worked numeric example (illustrative)
Assumptions:
– Contract: 1,000 barrels of crude oil.
– Initial oil price at entry: $45.00 per barrel.
– Notional contract value = 1,000 × $45 = $45,000.
– Broker requires initial margin = $3,700.
– Later price at expiry: $60.00 per barrel.
Profit calculation:
– Price change per barrel = $60 − $45 = $15.00.
– Total profit = $15 × 1,000 = $15,000.
– Return on initial margin = $15,000 / $3,700 ≈ 405%.
Notes: This example
Notes: This example is illustrative and omits real‑world frictions. It ignores commissions and exchange fees, bid/ask spreads, daily mark‑to‑market (variation margin), potential maintenance margin requirements, interest or financing costs, slippage when entering/exiting, and tax treatment. It also assumes the trader met any required maintenance margin and did not face intraday margin calls that could have forced an earlier exit.
Loss scenario and margin mechanics (worked numeric example)
– Same contract: 1,000 barrels; entry price = $45.00; initial margin = $3,700.
– If price falls to $30.00 at expiry:
– Price change per barrel = $30 − $45 = −$15.00.
– Total loss = −$15 × 1,000 = −$15,000.
– That loss exceeds the initial margin by $15,000 − $3,700 = $11,300, meaning the trader must fund additional capital as losses are marked to market daily.
– Mark‑to‑market explanation: futures positions are settled daily. Gains are credited and losses debited each trading day into the margin account; if the account falls below the maintenance margin, the broker issues a margin call requiring immediate funds.
– Example margin‑call math (illustrative):
– Assume maintenance margin = $2,700. After a loss that reduces the account balance to $2,000, the broker requires $700 to restore margin. If the trader cannot provide funds, the broker may liquidate positions, possibly locking in larger losses.
How rolling a contract works (step‑by‑step with numbers)
– Goal: keep exposure beyond the current contract’s expiry by closing the near contract and opening a later one.
– Step 1 — Close near contract: sell to close the front‑month at the then‑market price.
– Example: you entered long at $45.00 and the front‑month is now $60.00; closing yields +$15,000 (before fees).
– Step 2 — Open next contract: buy the next month at its market price.
– If the next month trades at $61.00, opening costs −$1.00 × 1,000 = −$1,000 (plus margin requirement for the new position).
– Net effect of the roll: realized gain from old contract minus cost to establish the new one. In the numbers above: +$15,000 − $1,000 = +$14,000 before fees and taxes.
– Practical considerations: calendar spreads (difference between contracts) can be large; commissions and slippage reduce net proceeds; new initial margin must be available; some traders roll with a spread order (sell one month, buy the next in a single transaction) to reduce execution risk.
Settlement types and deliverability
– Cash‑settled contracts: final settlement is a cash payment based on an index or spot reference; no physical delivery is required.
– Physically delivered contracts: at expiry the short must deliver the physical commodity to a delivery point; only a small percentage of contracts result in delivery because most traders close or roll positions before expiry.
– Check contract specifications: each futures contract specifies tick size, contract size, last trading day, delivery months, delivery procedures, and whether settlement is cash or physical.
Checklist before trading a commodity futures contract
– Read the contract specs on the exchange: tick value, contract size, margin requirements, expiry months.
– Confirm account permissions with your broker (futures approvals, margin profile).
– Calculate notional exposure and leverage: Notional = contract size × price. Leverage = Notional / required initial margin.
– Set loss limits: absolute dollar stop and percentage of account at risk.
– Plan for daily variation margin: ensure liquidity to meet margin calls.
– Factor in transaction costs: round‑trip commissions, exchange and clearing fees, possible slippage.
– Tax and accounting: understand tax treatment for futures (e.g., Section 1256 in U.S. tax code) and consult a tax professional.
– Practice with a simulator or small position size before scaling up.
Key definitions (brief)
– Notional value: contract size × underlying price; the total value of the position.
– Initial margin: the up‑front good‑faith deposit required to open a futures position.
– Maintenance margin: minimum equity that must be maintained to keep the position open.
– Variation margin: daily gains/losses that are settled to/from the margin account.
– Roll (rolling forward): closing the near contract and opening a later contract to maintain exposure.
Final remarks
Futures provide efficient leverage and price discovery for commodities, but leverage amplifies both gains and losses. Understand daily settlement mechanics, funding needs for margin calls, and contract specifics before trading. Use conservative position sizing and written trade plans. This information is educational, not individualized investment advice.
Sources
– Investopedia — Commodity Futures Contract: https://www.investopedia.com/terms/c/commodityfuturescontract.asp
– CME Group — Education on Futures: https://www.cmegroup.com/education.html
– Commodity Futures Trading Commission (CFTC) — Understanding Futures Markets: https://www.cftc.gov/LearnAndProtect/AdvisoriesAndArticles/futuresandinstrument
– National Futures Association (NFA) — Investor Resources: https://www.nfa.f
utures.org/investors/index.html