The ChoosaBroker Trading Academy
7.2. Understanding Derivatives and Futures Pricing
We hear or read about derivatives every day. But however much we read about them, they still seem confusing, to say the least. Welcome to the world of financial derivatives. In this lesson, we will try to demystify this class of instruments that has over the past couple of decades gained the interest of retail investors from across the globe.
How Do Commodity Futures Work
Commodities can be traded both in the spot and futures markets. Spot market prices are immediate delivery prices. For example, spot gold prices are currently shown as $1,300 per troy ounce. What this simply means is that if you were to walk in to a jewellery store, you could buy physical gold at $1,300 per ounce. Spot markets are typically used by consumers of commodities.
Alternatively, commodities can be bought and sold in the futures markets, which is the preferred route of speculators, investors and hedgers. Here, the commodities themselves are not traded. Instead, market participants enter in to agreements to buy or sell an underlying commodity at some future date.
Commodity futures contract are standardized legal agreements to buy or sell a defined quantity of an underlying commodity at a pre-determined price at a specified time in the future. The pre-determined price at which the buyer and the seller agree to enter in to the contract is referred to as the “forward price.” The specified time in the future is called the “delivery date.”
Commodity futures contracts are negotiated at regulated exchanges that act as a marketplace between the buyers and the sellers. The buyer of the contract is said to be holding a long position, while the seller is said to be the short position holder. As both parties are at risk of the counter-party walking away in case prices go against them, the contract typically stipulates that both parties deposit a percentage of the total value of the contract as “margin” with the exchange.
For example, 1 standard gold futures contract on the Chicago Mercantile Exchange controls 100 troy ounces of the metal. If gold is currently trading at $1,300 per ounce, the value of the contract is $130,000 ($1,300 x 100 ounces). Now, depending on the volatility in spot gold prices, the exchange may demand anywhere between 2% and 20% as initial margin to initiate a long or short position in gold futures.
The buyer and seller of a commodity futures contract have obligations. The buyer is required to take delivery of the commodity and pay the price specified in the contract. The seller is obligated to deliver the pre-determined quantity of the commodity, for which he or she will receive the price. The buyer and seller can both eliminate this obligation by entering in to offsetting trades at the exchange before the contract becomes due. If the initial investment was a “buy”, an equal number of futures contracts are sold to neutralize the position. Conversely, to offset an initial “sell”, a purchase is made to neutralize the position. This is what the overwhelming majority of speculators do.
How Are Commodity Futures Priced
Commodity futures are priced relative to their underlying assets. They are priced on the assumption that there exists no-arbitrage opportunity, or risk free profit. This no-arbitrage market condition assures an investor that the return from holding either the underlying commodity or the corresponding future will be the same.
In general, futures prices track spot commodity prices very closely during the lifetime of the futures contract, with the two eventually becoming equal at maturity of the contract. However, before expiry of the contract, future prices and spot prices need not be the same. The difference between two is termed as the “basis” of the futures contract. The basis can be positive, negative or zero.
If the spot price is above the futures price, a positive basis is said to exist. A negative basis is a situation where the spot price is below the futures price. Demand-supply imbalance is one of the key reasons behind this change in the basis. If short-term demand remains strong while the available supply shrinks, spot prices tend to gain relative to futures price, prompting the basis to strengthen. Contrarily, if demand is weak and a large batch of supply becomes available, spot prices are likely to decline relative to the futures price, forcing the basis to weaken.
Advantages of Trading Commodity Futures
- Portfolio Diversification Portfolio diversification through commodity market investment can greatly reduce unsystematic market risks. Investors positioned in more than one market should expect to see their losses balanced out by gains in negatively correlated markets.
- Hedge Against Inflation Another compelling reason for people to invest in commodities is that it provides an excellent hedge against inflation. Inflation implies that the price of goods and services has increased. That being the case, the value of commodities needed to produce those goods and services will also automatically appreciate. By exposing your portfolio to some commodities, you can take advantage of this relative outperformance during periods of higher inflation.
- Availability of Leverage Futures in general, and commodity futures in particular, operate on margin, meaning that to enter in to a long or a short position only a fraction of the total value of the contract should be available in cash in your trading account. This ability to control much larger positions with relatively low capital outlay can greatly enhance your rate of return. But traders need to be always aware that the small margin requirements can also potentially encourage excessive risk taking.
Commodity futures may at first glance seem like a lucrative investment option. They no doubt are. But behind the promise of unprecedented returns also lie the prospect of serious losses. Understand the instrument clearly, chart out a game plan, and define your risk appetite before you kick-start your futures trading career.