Commodity Futures Contract

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Commodity Futures Contract

Definition

A commodity futures contract is a standardized agreement to buy or sell a specified quantity of a commodity at a predetermined price on a future date. Futures create a binding obligation: unless the position is closed before expiration, the holder must buy or sell the underlying commodity at the contract price.

Key takeaways

  • Futures obligate the buyer or seller to transact the underlying commodity at a set price and date.
  • They are used for hedging price risk or for speculation via long or short positions.
  • Futures use margin and leverage, which can amplify gains and losses.
  • In the U.S., gains and losses on many futures are reported on IRS Form 6781 (classified as Section 1256 contracts).

How futures work

  • Contracts are standardized (quantity, quality, delivery months) and trade on regulated exchanges. Each contract is typically identified by its expiration month.
  • Most positions are closed or netted before expiration; the net difference is cash-settled. Some contracts permit physical delivery to approved warehouses.
  • Typical underlying commodities include crude oil, natural gas, gold, silver, corn, and wheat.
  • Traders post an initial margin (a fraction of the contract’s notional value) and must maintain maintenance margin. If losses erode the account, the broker issues a margin call requiring additional funds.
  • Futures vs forwards: both lock future prices, but futures trade on exchanges with standardized terms and clearing; forwards are OTC and customizable.

Speculating with futures

  • Speculators take directional bets by going long (buy) or short (sell) futures. Leverage lets traders control large exposures with relatively small capital.
  • Example: an initial margin of $3,700 might permit control of 1,000 barrels of oil valued at $45,000 ($45/barrel). If price rises to $60, the position gains $15,000 (1,000 × $15), producing a large return relative to the margin.
  • Risks:
  • Leverage magnifies losses and can trigger margin calls.
  • Futures are obligations; failure to close a losing position can result in unexpected delivery requirements.
  • Futures trading is advanced and may not suit most investors’ risk tolerance.

Hedging with futures

  • Businesses use futures to lock in prices for inputs or outputs, reducing uncertainty from volatile commodity prices.
  • Example: a plastics producer locks in a future purchase price for natural gas by buying futures; if spot prices rise, gains on the futures offset higher input costs.
  • Farmer example: a producer expecting 1,000,000 bushels of soybeans can sell 200 one-year futures contracts (5,000 bushels per contract) to lock a $15/bushel selling price. This stabilizes revenue but also forgoes upside if market prices rise above the hedge price.
  • Hedging risks:
  • Missed gains if prices move favorably after hedging.
  • Over-hedging can force unwinding at a loss if needs were overestimated.

Pros and cons

Pros
* Margin accounts require only a fraction of contract value.
* Both speculators and hedgers can take long or short positions.
* Businesses can manage commodity price risk and stabilize costs or revenues.

Cons
* High leverage can cause substantial losses and margin calls.
* Hedging fixes prices and may eliminate potential gains.
* Misjudging hedging needs can lead to costly unwind transactions.

How to start trading futures

  1. Choose a regulated futures broker that fits your needs and product range.
  2. Complete required account documentation and obtain margin approval.
  3. Fund the account with sufficient capital for initial and maintenance margins.
  4. Develop a clear trading or hedging plan aligned with risk tolerance and objectives.
  5. Begin with small positions and avoid overtrading.

Regulation and taxation

  • In the U.S., futures markets are regulated by the Commodity Futures Trading Commission (CFTC), which oversees market integrity and investor protection.
  • Tax reporting for many futures is handled under Section 1256 rules; traders typically report gains and losses on IRS Form 6781.

Common questions

  • Are futures transferable? Yes—standardization makes them readily tradable on exchanges, but contractual obligations remain with the holder until closed or assigned.
  • Why use forwards or futures? To lock in prices and mitigate the risk of adverse price movements.
  • How are futures taxed? Many futures are treated as Section 1256 contracts and reported on Form 6781; consult a tax advisor for specifics.