| August 24, 2020
What are commodity futures?
A cotton farmer is expecting to produce a good quantity this season and is looking for the buyer. Company A is the leading textile industry and a potential customer for the cotton farmer. Here, Company A can use commodity futures to lock in a price for buying cotton at a date in the near future. Like other commodities, the price of cotton can fluctuate considerably. To reduce the risk of cost increase by the farmer, Company A locks in the price. Similarly, the farmer also hedges his position and mitigates the risk of cost decrease.
Contracts are the type of standardized derivative contract between two parties that agrees to buy and sell the underlying asset. This deal specifies the date in the future and the price at which this will eventually close.
The mechanism works in a simpler manner. Considering the example taken above, if the cotton price increases in the future date, Company A makes a profit. They will get the cotton at the low and agreed-upon price and can sell the same at the current higher market price.
However, if the price decreases, the cotton farmer will make money by selling the cotton at the specified higher than market rates.In India, commodity futures are traded on exchanges like Multi-Commodity Exchange (MCE) and National Commodity and Derivatives Exchange (NCDEX).
What are some of the advantages?
The commodity futures not only help the speculative traders in making money but they are also a big part of the importer/exporter trades and producer of any commodity.
- Leverage Value addition: In future trading, you are exposed to a much bigger position only by paying a fraction as margin. Also, the margin, in this case, is lower than equity or index futures.
- Diversification: For a rookie investor, it’s always advised not to put all their eggs in one basket. As proven historically, there is a low correlation between commodity and equity markets. Hence, it can turn out to be an excellent way of diversification in one’s portfolio.
- Transparency: As compared to forward contracts which are customizable over-the-counter traded contracts, they are traded on the exchange. Because of this, the price discovery mechanism is independent of buyer/seller intervention negating market manipulation.
- Hedging Instrument: You can easily hedge your portfolio against inflation with the help of commodities as they are closely associated with inflation.
- Controlling cost: As an industrialist, you always look for affordable raw material costs. This can be achieved by locking in the prices months before.
What are some of the disadvantages?
Despite the several advantages prescribed above, trading in the futures commodity is not everybody’s cup of tea. It involves an enormous amount of risk which often takes the shape of fear and rule out the retail players from the game forever. Some of the disadvantages to note are the following:
- High Leverage: Leverage is a two-edged sword that can either help in making you enormous profits or can disrupt everything. Lower margin with high exposure can lead to poor money management which can in turn lead to unnecessary risk-taking.
- Risk of physical delivery: In India, most of the commodity futures are settled in cash only but there still exists a high possibility of actual physical delivery of products like soya, oil, gold, etc.
- With the highly risky nature of this product, it is recommended to be traded only by the professionals and veteran traders.
- Highly volatile: These contracts are fluctuating in nature and is influenced by events from around the world.