What is a Commodity Futures Contract
A commodity futures contract is an agreement to buy or sell a predetermined amount of a commodity at a specific price on a specific date in the future. Buyers use such contracts to avoid the risks associated with the price fluctuations of a futures' underlying product or raw material. Sellers use futures contracts to lock in guaranteed prices for their products.
BREAKING DOWN Commodity Futures Contract
Commodities future contracts can be used by speculators to make directional price bets on raw materials. Trading in commodity futures contracts can be very risky for the inexperienced. One cause of this risk is the high amount of leverage involved in holding futures contracts. For example, for an initial margin of about $3,700, an investor can enter into a futures contract for 1,000 barrels of oil valued at $45,000 (with oil priced at $45 per barrel). Given this large amount of leverage, a very small move in the price of a commodity could result in large gains or losses compared to the initial margin. Unlike options, futures are the obligation of the purchase or sale of the underlying asset. Simply not closing an existing position could result in an inexperienced investor taking delivery of a large quantity of an unwanted commodity. Speculation using short positions in futures can lead to unlimited losses.
Commodity Futures Hedging Example
Buyers and sellers can use commodity futures contracts to lock in the purchase of sale prices weeks, months or years in advance. For example, assume that a farmer is expecting to produce 1,000,000 bushels of soybeans in the next 12 months. Typically, soybean futures contracts include the quantity of 5,000 bushels. If the farmer's break-even point on a bushel of soybeans is $10 per bushel and he sees that one-year futures contracts for soybeans are currently priced at $15 per bushel, it might be wise for him to lock in the $15 sales price per bushel by selling enough one-year soybean contracts to cover his harvest. In this example, that is (1,000,000 / 5,000 = 200 contracts).
One year later, regardless of price, the farmer delivers the 1,000,000 bushels and receives $15 x 200 x 5000, or $15,000,000. This price is locked in. But unless soybeans are priced at $15 per bushel in the spot market that day, the farmer has either received less than he could have or more. If soybean were priced at $13 per bushel, the farmer receives a $2 per bushel benefit from hedging, or $2,000,000. Likewise, if the beans were priced at $17 per bushels, the farmer misses out on an additional $2 per bushel profit.