Futures – Getting Started

Having seen a stock market crash in the recent financial crisis, many investors have moved their capital from stocks to commodities. With the current stock market still not recovering well as expected, many now believe that the commodities market will be the place for them to strike their pot of gold.

For many, the above shift in focus is valid. This is because many studies have shown that when stocks fall, commodities will rise. The most important study backing this negative correlation would be that by Barry Bannister. Having studied these markets for the past 130 years, he has proven and demonstrated that stocks and commodities have alternate leaderships in 18-year cycles. Since, since we just faced a stock market crash and commodities have not risen very much over the past decade, it should be valid to ascertain that the commodity bull is arriving or to be more optimistic, it has arrived.

With so much attention on commodities now, I believe that it is definitely important for investors to learn more about futures as they govern the buying and selling of commodities that greatly affect prices. By definition, futures are binding agreements between buyers and sellers where a fixed amount of commodities will be traded at a location at a specific future time for a fixed price. By law, any party violating the agreement will be liable for penalties. Because of this, it is therefore important for investors to know the basic structure of futures contracts in order to make informed and wise decisions.

Futures contracts have the following 4 main standards: quantity, delivery date and location, description and payment terms. All the following specifications above are important because they can greatly influence the type of commodities investors bought to be involved in.

For quantity, different futures contract use vary measures to determine the quantity to be traded. For example, 1 contract of corn can mean 5000 bushels but 1 contract for gold would mean 100 troy ounces. For others, 1 contract of oil can mean 1000 barrels for oil while that for copper is 25000 lbs. Since different commodities have varying standard quantities represented by 1 contract, prices for different futures are so different. Thus, it is advisable for investors to know the representation of standard quantities for futures contracts of the specific commodities that they are interested in.

For delivery date and location, the futures contract should state where and when the commodity is delivered. Different types of buyers will buy on different dates. For speculators, it is usually advisable for them to buy and sell the futures few months before the expected delivery date as they only aim to make money trading futures. For commodity buyers, they usually buy futures from speculators at dates near the delivery date in order to get good prices for the commodities they need.

For description, the futures contract should state what commodity it is used for. This is important because not all commodities have the desirable characteristics (eg demand and supply) investors are looking out for. Also, different commodities are represented by different symbols. For example, corn is represented by C while cocoa is represented by CC. Here, investors should also familiarize themselves with the symbols represented by the commodities they have interest in.

For payment terms, the futures contract should state the number of days before delivery Buyers are required to pay in cash. Since the transaction is in cash, it should be noted that speculators bought to leave the market before the specific number of days before delivery arrives in order to prevent heavy losses, unless there are better reasons not to do so.

To conclude, I would like to give the readers a message I always believed in. Always seek to educate yourself with information on investments as information + education = knowledge. Remember that although information can become outdated, knowledge will not.