The motive of a speculator is to realize a profit on a position in a futures contract based on change in the value of the futures contract. A speculator will buy or take a long futures position when they expect the value of the commodity to increase.An investor or speculator who feels that the price of the commodity is likely to decline would establish a short futures position in an effort to profit from the falling commodity price. To determine the profit or loss on a speculative futures position one must look at all of the following:
- The number of units per contract
- The price per unit per contract
- The price at which the contract was opened
- The price at which the position was offset or closed
- The number of contracts
How are Futures Contracts Priced?
Each commodities futures contract has specific pricing characteristics that are set by the exchange and designed to reflect the needs of the market participants who use the commodity. The amount of the underlying commodity covered in a futures contract, the pricing increments, and the expiration months traded are all established with the production and use of the commodity in mind.
Contract Sizing and Prices
Each commodities futures contract represents a stated amount of the under- lying commodity and is priced in increments that reflect the price per unit of the underlying commodity. For example, a corn contract represents 5,000 bushels of corn and is priced in cents per bushel. Alternatively a gold futures contract that covers 100 troy ounces of gold is priced in dollars and cents per troy ounce. One troy ounce is equal to 1.09714 ounces.
Hedgers are always the users or producers of a commodity who are seeking to reduce or eliminate business risk that can result from an adverse change in the price of the commodity. The hedger is not seeking to profit outright from a position in a futures contract. Any profit on the futures contract will be used to offset the negative impact of an adverse price movement in the underlying commodity. Hedgers take futures positions that are opposite to their position in the underlying cash commodity. There are two types of hedgers, long hedgers and short hedgers. The type of hedger gets their name from the position that they take in the futures market to hedge their risk in the cash market. A long hedger will purchase futures to protect from the risk of the price of the commodity going up. A long hedger is someone who uses the commodity or who is contractually obligated to deliver the cash commodity but who does not own the cash commodity. If a business has a need for or an obligation to deliver the physical commodity, they are considered to be short the cash commodity or short the basis. Any increase in the price of the cash commodity will have a negative impact on their business, will reduce their profits, or may cause the business to suffer a loss.
What are Futures and Forwards?
While commodity futures contracts are seen by many market participants as strictly financial instruments, commodity futures contracts are truly an evolution of market efficiency. Commodity futures contracts have allowed the producer and user of commodities to operate their business more efficiently and to manage risk associated with changing prices.
The Spot Market
Before the development of financial instruments and contracts, commodities were bought and sold in cash transactions. The transactions between the producer or seller of the commodity and the user or buyer of the commodity took place in the cash or spot market. In the spot market the producer of the commodity would bring his crop to the marketplace and sell the wheat or corn to any buyer with cash in hand. The spot market gets its name from the fact that the commodity is delivered and paid for “on the spot.” The producer of the commodity who has the commodity on hand is said to be long the cash commodity.