TradingKey - This article introduces the fundamental concepts of commodity trading, helping you understand pricing and familiarize yourself with futures contracts.

Commodity trading has two primary methods: spot trading and futures trading.

Spot trading involves immediate payment and delivery.

In the spot market, buyers and sellers quickly exchange goods for cash based on current market prices, with ownership transferring instantly.

Futures trading involves a contract between buyers and sellers to deliver a specific quantity of goods at an agreed price on a specified future date.

The prices you encounter on trading platforms generally fall into two categories:

Spot Price

The spot price often called the cash price, represents the present market value of a commodity that can be delivered and settled right away.

For instance, when you buy apples at the supermarket today, you're paying the spot price. This price is influenced by the current levels of supply and demand. For instance, if a sudden flood damages orchards in an area, the spot price of apples might surge due to fears of limited availability.

Futures Price

The futures price is an agreed-upon price for a transaction set to occur on a specific future date.

For example, if you arrange to purchase crude oil at $80 per barrel three months from now.

This price is influenced by future expectations; if the market anticipates extremely cold weather next month leading to increased demand for heating oil, even if the current supply is plentiful, the futures price could rise in anticipation.

It's also important to note that different commodities are quoted using different units.

For example, wheat is often quoted in cents per bushel—"1153.00" translates to $11.53 per bushel. In contrast, rice may be priced in cents per hundredweight, meaning a quote of "1827.00" equals $18.27 per hundredweight.

It may seem a bit confusing at first, but don’t worry—just pay attention to product details while trading and you'll become more familiar with it over time.

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Curious about what a futures contract is? Think of it as a "commitment for future trading"—an agreement between buyers and sellers to exchange a specific asset, such as crude oil, gold, or soybeans, at an agreed-upon price on a specified future date.

Regardless of whether the market price rises or falls by that time, both parties are obligated to honor the contract.

This standardized agreement is a type of financial derivative that allows traders to speculate on market movements while enabling businesses to lock in costs and manage risks.

Futures contracts are traded on platforms like the New York Mercantile Exchange and the Chicago Futures Exchange.

These platforms ensure that every transaction is transparent and standardized, minimizing concerns about counterparty default.

An essential aspect of futures trading is the margin system.

Instead of paying the full value of the contract upfront, you only need to deposit a small percentage as "collateral" (the initial margin), typically ranging from 5% to 15% of the contract's value.

This leverage allows you to control larger positions; for example, using a 5% margin means that if prices rise by 10%, your returns could double.

However, if prices fall by 10%, you could risk losing half your principal—indicating that risk and reward are directly proportional.

Additionally, futures contracts are marked to market daily.

For example, if you buy crude oil futures today and its price drops by market close, your account will reflect this loss against your margin balance.

If losses exceed your margin limit and fall below the exchange's minimum requirement, you'll receive a "margin call," requiring you to fund additional capital promptly; otherwise, your position may be forcibly liquidated.

It’s essential to keep this in mind.

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Physical Delivery

This method is used for tangible commodities.

For instance, if you buy 100 barrels of crude oil futures, you will receive the physical oil on the agreed-upon date (although most individual investors typically don’t take actual delivery, as exchanges restrict personal participation in physical transactions).

Farmers selling wheat futures and factories buying copper futures often do so to ensure actual delivery or receipt at expiration, thereby stabilizing production supply—similar to a pre-signed "supply contract."

Cash Settlement

In this approach, there’s no need for physical delivery; instead, gains and losses are settled in cash.

This involves a cash transaction that reflects the market price of the corresponding asset upon expiration.

What Are the Types of Futures Contracts?

Futures contracts can generally be classified into two categories: standardized contracts and customized contracts.

Standardized Contracts

The contract size, expiration dates, and delivery rules are predetermined by exchanges.

For example, soybean futures at the Chicago Mercantile Exchange represent a fixed quantity of 5,000 bushels with set expiration months such as March, May, or July.

These uniform rules enhance liquidity by allowing traders to easily buy and sell within the exchange framework.

Customized Contracts:

These agreements are designed to fulfill the specific requirements of the parties involved.

They allow for modifications to contract terms to accommodate unique requirements like specific delivery dates or quantities.