Commodity Futures Questions and Answers
We put together a list of common questions and answers related to Commodity Futures Trading. This article will help you learn common Commodity Futures terminology.
When trading Commodity Futures – what is the difference between Initial margin and Maintenance margin?
Initial margin is the equity required to initiate a commodity futures position, it is a performance bond. Maintenance margin is the amount required to maintain the commodity futures position after initiation. Both the initial and maintenance margin are set by the commodity futures exchange.
What is the difference between physical delivery and cash settlement?
Physical delivery is the actual delivery of the asset by the seller of the contract to the commodity futures exchange, and the exchange then delivers the contract to the buyer. Physical delivery occurs mostly with commodity futures contracts and interest rate or bond futures contracts.
In reality, actual delivery of commodity futures occurs infrequently. Most contacts are cancelled each other by buying a contract to cover an existing short position or liquidating a contract that was previously purchased.
Cash settlement occurs when a cash payment is made based on the actual closing value of the actual underlying market. Cash settlement typically applies to stock index futures contracts and short term interest rate futures such as T-Bills.
The trade is settled when each side of the transaction receives the profit and/or loss related to each side of the transaction. Cash settlement is similar to the profit and loss scenario of a typical stock trade, where the buyer receives the profit of the trade and the other receives the loss.
What is the difference between a Commodity Futures Speculator and a Commodity Futures Hedger?
Hedgers and Speculators are the two main group of participants in Commodity Futures Trading. Hedgers actually hold the underlying asset with the goal of protecting or hedging against the risk of change in the price of the asset.
Hedgers include mostly producers such as farmers or holders of specific assets that are strongly impacted by rise or fall in commodity prices. For example, farmers commonly sell commodity contracts for crops they produce to lock in a specified prices.
While speculators do not hold the actual asset and are simply predicting the change in market price. Unlike hedgers, speculators do not have a use for the actual asset and never desire to take actual delivery of the contract. have no practical use for or intent to actually take or make delivery of the underlying asset.
Speculators make up the majority of the trading on the exchange and fall into three primary groups. The first group is made up of position traders or investors. This group of speculators typically holds positions for extended periods of time, sometimes lasting several months or years.
The second biggest group of traders are swing traders. This group of traders holds trades anywhere from a few days to several weeks. This category of speculators is sometimes referred to as short term traders.
The final group of traders is categorized as day traders and this group has been increasing in numbers in recent years. Day traders enter and exit positions during one trading session, sometimes several times over the course of a few hours.
How Do Traders Analyze Commodity Futures?
Commodities and Futures are mostly analyzed using fundamental analysis or technical analysis and some traders prefer to use both analysis methods when analyzing commodities and/futures contracts.
Technical analysis is the study of actual chart patterns and technical indicators that are created using mathematical formulas. The theory behind technical analysis is markets behavior represents the knowledge of all the buyers and sellers trading the market and therefore everything is priced into actual market price.
Fundamental analysis on the other hand is based on studying and projecting supply and demand in addition to weather and political events to gain a better understanding of future price movement.
Many traders use a combination of fundamental analysis and technical analysis to create their own unique strategies and tactics for trading commodity futures contracts.
Important Commodity Futures Concepts
Commodity Futures Spreads
Commodity futures spreads is a combination of multiple related contracts that are either the same commodity in different calender months or conversely, a different closely related commodity that has a very high correlation. The profit and/or loss on spreads is made when the two commodities move in either closer together or further apart from each other.
Placing Stop Orders
Stop orders can either be buy stops or sell stops. A buy stop orders is an order placed above the current market price and turn into market orders when the higher market price is traded. A sell stop order is placed below the current market price and turns into a market order when the lower price is traded. Stop orders are some of the most common types of orders.
Commodity Futures Options are derivatives from actual commodity futures contracts. There are two different types of options. Call options are contracts that give you the right to buy a commodity futures contract at a specified price. Put options are exactly the opposite of Call options, they are contracts to sell a commodity futures contract at a specified price.
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