How to Trade Commodities in Futures Contracts
The commodity futures market is divided into two segments: one that’s regulated and another one that’s unregulated. Trading in the regulated portion of the futures market is done through designated commodity futures exchanges such as the New York Board of Trade (NYBOT) — now part of the Intercontinental Exchange (ICE) — and the Chicago Mercantile Exchange (CME).
Trading in the unregulated portion of the futures market is done by individual parties outside the purview of the exchanges. This is known as the over-the-counter (OTC) market.
The futures market is the opposite of the cash market, often known as the spot market, because transactions take place right away, or on the spot.
A futures contract is a highly standardized financial instrument in which two parties enter into an agreement to exchange an underlying security (such as soybeans, palladium, or ethanol) at a mutually agreed-upon price at a specific time in the future — which is why it’s called a futures contract.
Futures contracts, by definition, trade on designated commodity futures exchanges, such as the London Metal Exchange (LME) or the Chicago Mercantile Exchange (CME). The exchanges provide liquidity and transparency to all market participants. However, the structure of the futures market is such that only about 20 percent of market activity takes place in the exchange arena.
The overwhelming majority of transactions in the futures markets take place in the OTC market. The OTC market usually involves two market participants that establish the terms of their agreements through forward contracts. Forwards are similar to futures contracts, except that they trade in the OTC market and thus allow the parties to come up with flexible and individualized terms for their agreements.
Generally, the OTC market isn’t suitable for individual investors who seek speculative opportunities because it consists primarily of large commercial users (such as oil companies and airlines) who use it solely for hedging purposes.
Despite the fact that futures contracts are designed to accommodate delivery of physical commodities, such delivery rarely takes place because the primary purpose of the futures markets is to minimize risk and maximize profits.
The futures market, unlike the cash or spot market, isn’t intended to serve as the primary exchange of physical commodities. Instead, it’s a market where buyers and sellers transact with each other for hedging and speculative purposes. Out of the billions of contracts traded on commodity futures exchanges each year, only about 2 percent of these contracts result in the actual physical delivery of a commodity.
In the land of futures contracts, both the buyer and the seller have the right and the obligation to fulfill the contract’s terms. This process works differently than in the realm of options: With options, the buyer has the right but not the obligation to exercise the option, and the seller has the obligation but not the right to fulfill her contractual obligations.