Commodity Products – Futures, Forwards and Options: (Features and Mechanics of Buying/Selling)

Commodity Products refer to standardized, tradable goods such as metals, energy, and agricultural items that are bought and sold on exchanges. These products include futures, forwards, and options that allow investors to hedge against price fluctuations or speculate for profit. Commodity products are vital for ensuring price discovery, managing supply chains, and supporting economic stability across global markets through transparent and regulated trading mechanisms.

Futures Contracts:

Futures contracts are standardized agreements traded on recognized exchanges to buy or sell a specific quantity of a commodity at a predetermined price and date in the future. These contracts are legally binding and highly regulated.

Features:

• Standardization: Futures contracts are uniform in terms of quantity, quality, and delivery dates, making them ideal for exchange trading.

• Regulated Exchanges: Traded on regulated exchanges like MCX or NCDEX in India, ensuring transparency and risk management.

• Margin System: Traders are required to maintain initial and maintenance margins to cover potential losses.

• Daily Settlement (Mark-to-Market): Gains or losses are settled daily based on closing market prices.

• Hedging Tool: Widely used by producers, processors, and traders to hedge against price fluctuations in commodities.

• Speculation: Speculators enter futures markets to profit from anticipated price movements without intent for physical delivery.

• Liquidity: Due to standardized contracts and active participation, futures markets are highly liquid.

• Contract Expiry: Contracts expire on a specific date, and positions must be closed or result in delivery.

Mechanics of Buying/Selling:

• Opening a Trading Account: Traders must open a commodity trading account with a registered broker.

• Placing Orders: Buy or sell orders are placed via terminals or online platforms, specifying contract, quantity, and price.

• Margin Requirement: Initial margins are paid upfront, and positions are marked-to-market daily.

• Clearing and Settlement: The clearing house acts as a counterparty, ensuring trades are honored.

• Delivery or Cash Settlement: On expiry, contracts are either settled in cash or delivery depending on the trader’s position and exchange rules.

Forward Contracts:

Forward contract is a customized agreement between two parties to buy or sell a specific commodity at a future date for a price agreed upon today. Unlike futures, forward contracts are traded over-the-counter (OTC), not on exchanges.

Features:

• Customization: Terms of quantity, quality, price, and delivery date are negotiated privately between the buyer and seller.

• OTC Nature: These are private agreements and not governed by exchange rules.

• No Standardization: Unlike futures, forwards are not standardized, which allows flexibility.

• Counterparty Risk: Higher risk exists as there’s no intermediary or clearinghouse to guarantee performance.

• No Daily Settlement: Payment is made at contract maturity; no mark-to-market adjustments.

• Used by Businesses: Primarily used by producers, exporters, and importers for hedging specific commodity needs.

• Non-Transferable: Typically not transferable or tradable in secondary markets.

• Delivery-Based: Forward contracts usually result in actual delivery of the commodity.

Mechanics of Buying/Selling:

• Negotiation: Both parties discuss and agree on price, delivery date, quantity, and other terms.

• Documentation: A contract or agreement is drawn outlining all agreed terms and conditions.

• No Margin: Generally, no upfront margin is required, but parties may agree on partial payments or guarantees.

• Execution: On the due date, the buyer pays the agreed amount and receives the commodity.

• Settlement Risk: If prices fluctuate drastically, one party may default, making legal enforcement critical.

Options on Commodities:

Commodity options are derivative contracts that provide the buyer the right, but not the obligation, to buy (Call Option) or sell (Put Option) a specific quantity of a commodity at a predetermined price on or before a specific date.

Features:

• Right without Obligation: The buyer can choose to exercise the contract; the seller (writer) has an obligation if the option is exercised.

• Premium Payment: Buyers pay a premium to the seller upfront to acquire the option.

• Limited Risk for Buyer: Maximum loss is limited to the premium paid, while potential profit is unlimited.

• Types of Options:

  • Call Option: Gives the right to buy.

  • Put Option: Gives the right to sell.

• Strike Price: The agreed price at which the commodity can be bought or sold.

• Expiry Date: Options have a limited life and must be exercised on or before the expiration date.

• American vs European Options: American options can be exercised anytime before expiry; European options only on the expiry date.

• Trading Platform: Options are traded on exchanges like MCX in India under regulatory frameworks.

Mechanics of Buying/Selling:

• Premium Payment: The buyer pays a premium to acquire the option; no margin is required for the buyer.

• Option Writing: The seller (writer) receives the premium and must maintain margins since their risk is unlimited.

• Exercising the Option: If market conditions are favorable (in-the-money), the buyer may exercise the option. If not, the option expires worthless.

• Payoff Profiles:

  • Call Buyer: Profits if market price > strike price + premium.

  • Put Buyer: Profits if market price < strike price – premium.

• Risk Management: Commonly used for hedging by producers and traders to protect against adverse price movements.

• Settlement: Depending on the exchange and contract, settlement may be physical or cash-based.