Whether you are new to investing in commodities or a seasoned pro, it helps to understand the two primary commodities contracts through which most commodities trades are carried out. Failure to comprehend these contracts fully can result in devastating losses. The two contracts are options and margins.
When people speak of investing in commodities, what they really mean is that they are investing in commodities futures. Commodities investing involves entering a contract to purchase bulk raw materials at a specified price to be delivered on a future date certain. The seller is hoping to secure a stable price for goods while the buyer is seeking to either lock in commodities needed at a particular price or speculating that the cash or spot price will rise on or before the settlement date and the goods can be sold for a nice profit. It is for this latter reason that most commodities contracts are bought and sold many times and the buyers will seldom take possession of the commodities.
In an options contract, the buyer agrees to buy commodities at a set price on a date certain in the future. However, the buyer is under no obligation to accept delivery of the underlying commodities. If the price rises, the buyer sells the option contract. If the prices begin to fall, the buyer can sell the contract and try to recoup some of the money paid for the option. Or, the buyer can just walk away in which case all that is lost is the fee paid for the option. One of the great benefits of this commodities contract is that a large volume of goods can be controlled for a small price.
The margins commodities contract is similar with one main difference. The buyer is under an obligation to accept delivery of the goods so that in the event of falling prices, the buyer will have to sell the contract and pay the original seller the difference in the amount received and what was promised. Thus, under a margin contract, the investor could lose a lot of money very quickly, although the investor could also make a lot of money just as quickly.