If you are wondering what commodity futures are, you might be new to derivatives trading. A derivative trading is when you deal with speculation regarding underlying assets. By definition, a financial instrument is known as a derivative when its value is obtained from that of another asset which is called underlying. This asset can be a commodity, a stock, a market index and so forth. Futures contracts are a type of derivatives instruments.
Commodity futures or commodity futures trading deals with the agreements to buy or sell a certain amount of a commodity such as gold, crude oil, food grains and such, at a fixed price at a future date. Commodity futures contracts are made by buyers who want to minimize their risk of price fluctuations of the goods that they intend to buy in the future while the sellers want an assured price for their produce. Many use such contracts to speculate on price movements as well.
Commodity futures are risky investments, especially for those who may be playing in commodity futures trading for the first time. There is usually a high amount of leverage involved which makes futures contracts come with a great amount of risk. For instance, for a margin of $5000 an investor gets into a commodity futures contract agreeing to buy 1000 barrels at $50,000 at a certain date in the future. Since there is a large amount of leverage involved, even if there is a slight up or down movement in the price range, it can result in either gains or losses for the investor. Also, if he is unable to close the existing position, he is obliged under such a contract to pay and take delivery of the commodity whether he wants it or not.
In India the commodity futures market saw a revival since 2002-2003 when the Government of India announced several initiatives to be taken at the national level to set up commodity exchanges and rules and procedures governing such transactions. Along with the setting up of such commodity exchanges, the list of commodities to be included in such transactions was expanded as per the Forward Contracts (Regulation) Act,
1952. Also, the day restriction whereby any spot market transaction is to be completed has been removed and also, NTSD or Non Transferable Specific Delivery Contracts has been removed. These changes have been made to facilitate the use of futures contracts in commodity markets and to manage the associated risk with commodity futures.
The commodity market plays an important role for providing information and also for mitigating risks. The market acts as an intermediary between the buyers and sellers and helps to lay down rules and procedures regarding transactions of commodities or cash settlements and so forth.
The most common form of contracts in commodity exchanges are trade futures. These are agreements which are made between the buyer and seller of a commodity whereby the buyer agrees to buy a specified amount of the commodity from the seller at a future date as fixed in the contract. These are formed to hedge the risks in volatile and fluctuating price movements which prove harmful to both the producer and user of a commodity. For instance, if the commodity being traded is wheat, a farmer will want to get into such a contract by which he can be assured that, the produce which will be harvested in the coming months, will be sold at a fixed price no matter what the market price is at that time. On the other hand, a buyer stands to gain when he or she buys such a contract and hence buys the commodity only at the price mentioned even if the prices have gone up at the time of expiry of the contract.
Most of the currency futures allow transactions between the US dollar and the Indian rupee but other pairs are also permitted. Such transactions can only be done by Indian residents who may do so to hedge the associated risks with foreign exchange.