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What Is Commodity Futures Investing?

What Is Commodity Futures Investing?

The futures market encompass a wide range of products such as coffee, pork bellies, oil and foreign currencies. Commodities futures are a subset of the futures market which focuses primarily on organic products such as cotton, wheat and coffee beans.

To better understand what commodity futures investing entails we must first first look at what is a commodities futures contract. Commodities futures contracts are a hedge or guarantee for the producer of a commodity. What that means is when a cotton farmer takes a loan in order to grow a crop for a given year that farmer assumes a certain level of risk that they will be able to pay off the loan when the crop is harvested. That farmer may sell cotton futures contracts guaranteeing a certain price for the crop for future delivery.

This is done because the price of cotton on January 1 may be significantly lower when the crop is harvested resulting in a loss of income for the farmer. A futures contract seller, the farmer, is said to be "short" because the hope is the price will be lower and the contract purchaser is said to be "long" because the hope is the price will be higher for a given commodity.

Investing in commodities futures entails the buying and selling of futures contracts on a commodities exchange. A commodities future contract represents a fixed amount of an underlying asset which could be purchased at the futures contract strike date. However, most futures investors never take receipt of the underlying asset as most investors don't want 100 barrels of oil delivered to their home.

Much like options contracts, commodities futures contracts represent a fixed amount of an asset so one contract may equal 100 barrels of oil or 100 bushels of wheat. The futures contract is a percentage of the overall value of the underlying asset. When investing a $1,000 to purchase one futures oil contract it is representative of possibly $10,000 worth of oil.

Futures contracts are sold on margin so a small investment can represent a large amount of capital and if the direction of a commodities future is successfully predicted incredible amounts of money can be made. Unfortunately the opposite is true. If an investor makes a bad bet on a commodities future unlimited losses are also possible.

Commodities futures contracts is an incredibly high risk form of investing. Only the most sophisticated of investors should ever consider trading in commodities futures. Many brokers, including full service and online, offers futures trading as a service. There is normally a minimum investment of $10,000 just to establish a futures trading account. Commodity futures investing has a significant learning curve and can require years of experience before making money.

Fortunately, many brokerage houses allow for the creation of paper accounts which represent and act like standard futures trading accounts without using actual money from an investor. This is a great way to gain experience and knowledge while learning about commodities futures investing. Trading in futures contracts is not for every investor but for those sophisticated enough and with enough capital, it is a viable option for making significant investment returns.

Image by: Scott Butner