Commodities Trading
What is “Commodities Trading”?
Commodities are basic physical assets that are common inputs to manufacturing and production e.g. crude oil, pork bellies, and copper. Commodities are traded on spot and futures commodity markets. In order to be exchangeable, commodities need to be standardized and defined, particularly when they are traded on an exchange. The trading contract specifications ensure that the commodity traded has a uniform, defined characteristics.
The first type of commodity market is the spot market, also referred to as physical trading. This is the market where participants exchange commodities for cash. So, commodities are bought and sold for immediate delivery and payment.
The second type of commodity market is where commodity trading takes place in the futures market. Futures are contracts to buy or sell a specific amount of commodities at the agreed-upon price i.e. the price of the transaction is agreed upon the trade date but settlement occurs at a specific date in the future. Market participants pay a lot of attention to the shape of the futures curve. To describe the shape of the commodities futures curve, market participants use the terms contango and backwardation. Investors prefer to invest in commodities via the futures market, rather than the spot market because they do not have to take physical possession of the commodity.
Key Learning Points
- Commodities are tradeable raw materials, usually inputs to production
- There are two types of commodity market – spot and futures markets
- Investors often prefer to get exposed to commodity prices via the futures market, rather than the spot market
Why is the Futures Market Preferred to Spot Market?
While for pure financial assets, immediate delivery usually means two business days from the trade date, in commodities we often require a longer settlement period. This is due to the fact that often commodities are produced in one location and consumed in the other. And, as commodities are real goods, they have to be transported to the location where they are needed.
This also means that a significant amount of infrastructure and specific logistic expertise is required to facilitate this type of trading. This is why investors often prefer to get exposed to commodity prices via the futures market.
Futures are contracts to buy or sell a specific amount of commodities at the agreed-upon price i.e. the price of the transaction is agreed upon the trade date but settlement occurs at a specific date in the future. As positions in futures can generally be closed through offsetting trades prior to the settlement date even for contracts for physical settlement – buyers and sellers do not have to actually take or make delivery of the underlying goods.
Consequently, futures are a convenient way for producers and consumers to hedge their natural risk positions, as well as for investors to build exposure to commodity prices without having to deal with the physical goods and most commodities trading in practice takes place in the futures market for that reason.
Futures Contract Specifications
In order to trade in the market, commodities have to be standardized and defined, in order to be exchangeable. This is particularly true when traded on an exchange. Below are typical contract specifications that would be found on Crude Oil Futures Contract Specifications (also known as WTI futures and are traded on the CME).
Contract Size of Unit: 1000 barrels
Price Quotation: US Dollars or Cents per barrel. In other words, if you were to buy one futures contract for $56, this means that you agree to buy 1000 barrels of oil at $56 per barrel at futures expiry – which gives the contract a value of $56,000
Tick size: $0.01 per barrel – is defined as the smallest possible price change of the futures contract and it is $0.01 cents here, and as the contract is for 1000 barrels, the smallest possible change in the value of the contract is $10
Contracts: monthly contracts for the current and next 8 calendar years i.e. there are monthly contracts of around nine years into the future, which means that it is possible for producers and consumers to hedge their exposures quite far out
Specifications: the underlying commodity of these futures contracts is light sweet crude oil – of a specified grade and quality i.e. quality specifications as defined in the CME Rulebook Chapter 200. The important thing to remember in trading these futures is that they are actually physically settled. So, if positions are not closed before expiry, traders have to take delivery of the physical oil. Delivery shall be made free on board at any pipeline or storage facility in Cushing, Oklahoma.
The shape of the Futures Curve
Next, as commodity futures are so important in hedging and speculation, market participants pay a lot of attention to the shape of the futures curve. In general, a futures curve links the futures prices (USD) per barrel of WTI to the different expiry dates and shows the prices at which the commodities can be bought or sold for the various expiry months.
To describe the shape of the commodities futures curve, market participants use the terms contango and backwardation. Contango describes an upward sloping curve, which means futures prices increase with time to expiry and backwardation describes a downward sloping curve, so futures prices decrease with time to expiry.
Trading Commodity Futures Contracts
Commodity futures contracts may be traded solely for profit, as long as the trade is closed prior to the expiration date. Now suppose trader A is interested in making a profit on the price movement of crude oil, yet is hardly interested in receiving 1,000 barrels of oil. Below is an example of trading crude oil futures contracts.
Assume that it is June 1, 2020, and October 2020 contracts are trading at $85. If trader A believes that the price of crude oil will rise prior to the expiry of the contract in October, then this trader could purchase the contract at $85. Note, the trader is not required to pay $85,000 ($85 * 1,000) to control 1,000 barrels of oil. Instead, the broker will typically receive a payment of a few thousand dollars, which is termed as the initial margin payment.
The final profit or loss of this trade is realized upon the closure of the trade. For example, if trader A sells the contract at $95, he or she will make $10,000. Alternatively, if the price falls to $70 and they close out the position there, trader A will lose $15,000. The calculations are shown below, download the accompanying excel exercise sheets to practice doing the calculation yourself.
