Commodity spreads 2: What are futures contracts and how do they work?

I told you why I have chosen commodities in the first part of the series on commodity spreads, and today we can move forward. But before we go straight to the commodity spreads, it will be important to understand what the futures are.

How most commodities are traded?

Commodities can be traded on commodity exchange in different ways. The most frequent are futures contracts (shortly just futures). Let me explain this. Future indicates that the action will be made in the future and contract indicates some kind of agreement. And as you know, each contract contains some specifications that both counterparties must follow. And one of the important specifications is the expiration of the contract. Each contract has an expiration date in the future, when it will cease trading on the commodity exchange. This is precisely why these contracts are called futures, i.e. futures contracts.

When we decide to trade for example wheat, we have different contracts with different expirations, for example in December, March, July, etc. We can also say that expiration months correspond to the months when the commodity will be delivered in the future.

How does it work?

The principle of trading is very simple:

• When speculating on the rise of commodity price, we go long, we buy the contract.
• If we expect a fall of the commodity price, we go short and sell the contract.

 Example

For example, we expect the wheat price will increase, and therefore we will buy the March contract. This means that the contract will stop trading in March. If the wheat price actually grows and we will sell the contract, the difference between the entry and exit price will be our profit. If the wheat drops, this difference will be our loss.

However, if we do not manage to get rid of the contract and we do not sell it in time, we will get to the delivery process. What would that mean? Since we bought the wheat contract in our example, we have an obligation to take delivery of about 135 tons of wheat in March (contract size is also one of the important specifications). If, on the contrary, we sell the contract at the beginning and do not get rid of it in time, it is our duty to deliver 135 tonnes of wheat to the counterparty.

Do not worry!

Most brokers do not allow physical delivery of contracts. If the position is not closed in time, the broker automatically liquidates our position with sufficient time before the expiration. So we do not have to worry that tons of grain, or maybe cocoa, coffee, pork, etc. will land in our garden. We will not even have to deliver tons of sugar to someone for example 😀

If you wonder where you can find the contract specifications, HERE is the link to the CME Group website where you can find the specifications for corn.

What’s next?

We will not stop here as we will proceed directly to the popular spread trading. Since we know what commodities and futures are, we can now explain commodity spreads.