Some investors trade the commodities markets by using specialised instruments such as “commodity futures.” Learn what futures are and how commodities futures work.
Trading commodities can help you to diversify your portfolio, hedge risks associated with other asset classes, and potentially profit from price movements. In addition, commodity futures can help traders and investors to gain exposure to the sector, although they are not the only instrument that does so.
Understanding the positives and negatives of each market and method of trading commodities can help you to determine the most suitable match for your trading style and personal investment aims.
What are futures?
Futures are legally binding contracts for buying or selling an amount of an asset at a predetermined price on a specific future date. These contracts are traded on exchanges and are used to invest in a wide range of assets such as commodities, stocks, indices and forex.
Futures contracts are standardised according to the rules and regulations of each exchange. They are derivative instruments that require an initial margin payment when purchased. The transaction is fully settled on the designated “maturity” or “delivery” date. On this date, cash or assets are transferred between accounts under the guidance of the exchange.
Are commodities traded as futures?
Commodities futures are widely traded. They are aligned with the fundamental purpose of the commodity markets: to facilitate trade between raw material suppliers, big corporations and governments seeking physical commodities. Futures offer both parties a degree of certainty when it comes to pricing and delivery.
Speculators can also participate in commodity futures trading. They usually aim to buy or sell futures with the objective of making a capital gain before the maturity date of the contract. There is no requirement to hold a future for the full term of the contract, and any profits or losses can be converted into realised P&L by trading the futures during open exchange hours.
Speculative investors usually prefer to trade “non-deliverable” futures, where any price difference at maturity is settled via a cash transfer. Conversely, “deliverable futures,” which require physical delivery of raw materials, tend to be used by businesses for their day-to-day operations.
Trading commodity futures on an exchange is typically reserved for more experienced investors. The process involves an initial margin deposit, which can sometimes be substantial, and requires developing a full understanding of the process.
Futures trading also involves using leverage to take on greater exposure than the size of the initial cash deposit, which amplifies the impact of price movements on real-time profit and loss.
More user-friendly instruments have been created by brokers to allow clients to access the commodity sector, without taking on all of the risks and administrative duties associated with trading futures on an exchange. Some investors opt for commodity stocks, commodity ETFs (exchange-traded funds) or commodity CFDs (Contracts for Difference).
CFDs are also derivative instruments. However, the contract is between the investor and the broker, rather than the investor and the exchange. Certain CFDs even track the price of commodity futures such as wheat. These investments ensure that the profit or loss on a trade will still be determined by price moves in the underlying market, without the requirement of making a physical delivery.
Tip: Expiration days for futures contracts can lead to increased price volatility as participants enter or exit positions.
Most commonly traded commodity futures
As is the case with all financial markets, the trading volumes of commodity futures experience fluctuations in response to geopolitical and natural events. Moreover, long-term trends can lead to the amount of trading in a particular commodity to change over time.
It is possible to track trading activity by accessing data from the major commodity exchanges such as the Chicago Mercantile Exchange, London Metal Exchange and Tokyo Commodity Exchange.
Industry bodies also publish reports that consolidate trading data from various exchanges to provide insights into trading activity across the broader market. The below list was compiled from data published by the Futures Industry Association and Intercontinental Exchange, and details the top ten global commodity trading volumes:
Tip: Markets with higher trading activity and increased liquidity often exhibit tighter bid-ask spreads, resulting in reduced trading costs.
The differences between commodities and futures
Futures trading marked the first step in opening up the commodity markets to investors and speculators. As public interest has grown, other instruments, such as CFDs, have provided a new way for retail investors to access the market. While some investors still prefer trading futures, it is important that interested parties fully understand the positives and negatives of the different approaches.
Consider the pros and cons of trading commodity futures:
- Track price moves in the core market
- Highly liquid markets
- Standardised contract terms and conditions
- Can be used to buy or sell short
- Requires a margin account to be set up with the exchange
- Buying a deliverable future would result in physical delivery being made
- Using leverage is a high-risk style of trading
- Futures contracts can be large in size. For example, one cotton future equates to 50,000 lbs of the material.
On the other hand, here are the pros and cons of trading commodities using CFDs:
- Track price moves in the underlying asset
- Standardised contract terms and conditions
- Can trade in smaller size
- Can be used to buy or sell short
- Requires margin to be deposited with a broker
- Using leverage is a high-risk style of trading
- Higher risk than trading shares
- 79% of retail investors lose money when trading CFDs
Final thoughts
Due to the nature of commodities markets, it is important to establish which instrument is the best fit for your trading style. Commodity futures offer one option for trading the sector, but alternative choices are available. These alternatives offer equally accurate ways of tracking price moves, while mitigating some of the additional risks and responsibilities associated with trading futures.
Visit the eToro Academy to learn more about trading commodities.
Quiz
FAQs
- What is the difference between a future and an option?
-
Both futures and options are an agreement to buy or sell a quantity of an asset at a future date. However, in futures contracts, the involved parties are obligated to complete the transaction. On the other hand, options grant the holders the right to buy an asset, without ever being obligated to do so.
- What is margin?
-
Margin refers to the capital that an investor deposits with an exchange or broker as a down payment for a futures or CFD transaction. It is essentially a percentage of the total value of the transaction, with the required amount of margin varying depending on the asset being traded.
- What is the easiest way to gain exposure to commodities?
-
While commodity futures are a popular instrument among traders, there are alternative options for those looking to gain exposure to the commodities sector. For example, traders could consider buying stocks in firms operating in the commodities sector, such as Rio Tinto, or ETFs that allow you to buy a diversified basket of assets with just one trade.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments.
This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Not all of the financial instruments and services referred to are offered by eToro and any references to past performance of a financial instrument, index, or a packaged investment product are not, and should not be taken as, a reliable indicator of future results.
eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.