Commodity futures used to be inaccessible to anyone besides professional traders. However, in recent years, the average trader has gained access to commodity exchanges, and, accordingly, commodities futures. Unfortunately, many investors still choose not to trade commodity futures. Trading commodity futures could prove monumental for your portfolio. It’s an investor’s best interest to take the time to learn about commodity futures.
Why You Should Learn More About Commodity Futures
There are two primary reasons why even the most casual of investors could benefit from learning about commodity futures. First and foremost, equity investors now have more access than ever to futures in the ETF market. Not only does futures exposure come from exposure to commodity-specific ETFs, but it also comes from alternative ETFs.
Secondly, commodity futures are an excellent form of portfolio diversification. Commodity markets operate under basic economic principles where supply dictates demand, and so forth. Commodity markets are incredibly stable and are far less volatile than other securities futures. Additionally, experts view commodities as an underappreciated asset class, providing ample opportunity for long-term growth and diversification.
Basics Of The Futures Market
If you are an investor who is used to handling equities and options, there are a few things you’ll need to understand about the futures market. Most important is the fact that futures are not an asset. This is one of the most common misconceptions about futures. Futures are a contract that gives the investor the right to purchase or sell an asset at a later date.
Understanding The Futures Market
One of the primary differences between the futures market and the equity market is the use of the word “margins.” Investors are taught to avoid margins in the equity market because they represent leverage, which typically serves as a trap for a poor investment.
Margin, regarding the stock market, means that the investor has taken out a loan so that they can increase their exposure to a particular stock. If the stock fails, the investor will not only be out the principle but the interest accrued on the loan as well, resulting in an more significant loss.
However, margin, regarding a futures contract, represents the amount of money that investors deposit into a clearinghouse. Typically, clearinghouses will limit the Initial Margin deposit to less than ten percent of the rice of the future. Furthermore, clearinghouses require both buyers and sellers to deposit their margin into the account, which helps mitigate long-term risk as both entities will be able to close out their position.
Another critical difference in the futures market is how contracts are settled. Futures investors have the option to:
- Offset their position as the expiration date approaches
- Convert the agreement into a cash settlement
- Deliver the commodity
The exchange handles any cash conversions or delivery, although these outcomes are rare. However, the fact that owners could offset their position provides them with significant flexibility. Offsetting can help reduce exposure and the likelihood of taking a loss, which is why futures should serve as part of any long-term investing strategy.
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