Commodity Futures Explained: How a Futures Contract Works

A commodity futures contract is a standardised, exchange-traded agreement to buy or sell a fixed quantity of a commodity at a price agreed today, for delivery on a set date in the future. You do not pay the full value up front; you post margin, and gains and losses are settled every day through a clearing house. Almost all speculators close or roll their contracts before delivery, so they never touch the barrel or the bar.

From forwards to futures

Long before exchanges, a farmer and a miller could agree a private forward contract: "I will sell you 5,000 bushels of wheat in October at this price." Forwards are flexible but have two problems. Each one is custom, so it is hard to sell to someone else, and each side depends on the other keeping the promise.

A futures contract solves both problems:

• Standardised: the exchange fixes the quantity, quality, delivery place and dates, so every contract of the same month is identical and can be traded by anyone.
• Exchange traded: buyers and sellers meet in one central market with public prices.
• Cleared: a clearing house steps in after every trade. It becomes the buyer to every seller and the seller to every buyer, collects margin from both, and guarantees that winners get paid.
• Marked to market: gains and losses are settled in cash every day, so losses cannot pile up unseen.

The big commodity clearing houses belong to the exchanges, such as CME Clearing for CME Group markets and ICE Clear for ICE markets.

Long and short

• Long means you agreed to buy. You profit if the price rises.
• Short means you agreed to sell. You profit if the price falls.

In futures, going short is exactly as easy as going long. You do not need to own or borrow the commodity, because you are simply entering an agreement to sell. Every long position has a matching short position, so futures are a zero-sum market before costs: one side's gain is the other's loss.

The total number of contracts still open at the end of a day is the open interest. Rising open interest means new positions are being created; falling open interest means positions are being closed.

What the exchange standardises

Every futures contract has a specification sheet listing:

• Underlying: what exactly is traded, such as Henry Hub natural gas or COMEX gold.
• Contract size: for example 100 troy ounces of gold or 1,000 barrels of crude.
• Quality: COMEX gold must be at least 995 fineness (99.5% pure); WTI must meet a light, sweet crude specification.
• Delivery location: WTI is delivered at Cushing, Oklahoma; natural gas at the Henry Hub in Louisiana.
• Contract months and last trading day.
• Tick size: the smallest price step.
• Settlement method: physical delivery or cash.

You will put the size and tick to work in the lesson on contract specs and tick values.

Physical delivery and cash settlement

Physically delivered contracts, such as WTI crude (CL), Henry Hub natural gas (NG), COMEX gold (GC) and live cattle, can end with real goods changing hands. A long holder at expiry may have to take delivery of 1,000 barrels at Cushing.

Cash-settled contracts end with a final cash payment based on a reference price. ICE Brent crude settles against the ICE Brent Index, and CME lean hog and feeder cattle futures settle against published price indexes.

Retail brokers usually do not let individual clients hold physically delivered contracts into the delivery period, and many close positions automatically before then. The lesson on expiry and rolling explains the key dates.

Many months trade at once

At any moment, several delivery months of the same commodity trade side by side: December, January, February crude and so on. The nearest active month is the front month and is usually the most traded. The list of prices across all months is called the futures curve, and its shape tells you a lot about supply and storage, as you will see in the contango and backwardation lesson.

Who you trade with and how to start

To trade futures you need an account with a futures broker. In the United States these firms are called futures commission merchants (FCMs). In Pakistan, PMEX contracts are traded through its licensed brokers; to reach CME or ICE markets you need an international broker that accepts clients from your country. Check the broker's regulator, the margin it charges and its rules for closing positions before expiry.

Futures costs include the broker's commission, exchange and clearing fees, and slippage, the difference between the price you expected and the price you got. Costs per contract look small next to the contract's value, but they add up for frequent traders, and every roll means two extra trades.