Commodity futures are contracts to buy or sell a specific amount of a commodity at a certain price on a designated date. If the price of a commodity goes up before that date, a commodity futures buyer wins by getting a lower price on goods they can sell at higher value. Trading commodity futures lets you bet on the price of commodities including gold and corn. They can also be used to diversify your portfolio by investing in more than just stocks. Unlike stocks, however, commodities futures can cost their buyers even more money if the price of a commodity falls below the contracted price. Here’s what you need to know about investing in commodity futures.
As so eloquently described in the 1985 film “Trading Places,” commodities are naturally occurring or agricultural products that can be bought and sold.
Commodities include gold and crude oil, but also agricultural products like corn and coffee. Investing in commodities is investing in the products themselves, rather than the producers of those products. Where stock grants shares of ownership in a company, commodity trading provide ownership of the product itself.
Some commodities, like gold, often move counter-cyclically to the stock market. That means they tend to be strong while the stock market is weak and likewise. While options options and exchange-traded-products are both means of investing in commodities, commodity futures are far more basic.
Commodity Futures at a Glance
Commodity futures are contracts for buying and selling certain commodities. Investors agree to the price of a commodity at a certain date. The commodity is sold at that price regardless of its value when sold.
For example, a buyer could enter a commodity futures contract to purchase 1,000 pounds of coffee at $1.10 per pound on August 15. The seller agrees to sell you that amount of coffee at that price on that date.
When that date arrives, a commodity futures buyer can take delivery of those beans and sell them later. If a buyer isn’t particularly interested in shipping or selling coffee beans, the buyer or seller can take a cash settlement for the difference between the current price of the product and its contract price. Should the price rise before the contracted date, the buyer is paid. If it fell, the seller gets the dividends.
Commodity Futures as a Hedge
If you want to secure the price of goods in advance, commodities futures are one way to do it. If a grocer fears a recession ahead can attempt to stabilize its supply and pricing by entering a commodity futures contract in advance.
Meanwhile, an investor who senses imminent natural disaster and sees an opportunity to speculate on changing prices might consider commodities futures. That investor may never want the actual commodity, but they’ll want the cash settlement when the commodity they bought at a low price suddenly spikes in value.
Why Commodity Futures Are Risky
Commodity futures can not only drain your up-front costs, but can cost you even more if you’re on the losing end of the bargain.
For buyers, the risk is substantial, but capped at the amount you agreed to pay. In the coffee example, if your commodity future contract agreed to 1,000 pounds of coffee at $1.10 per pound on August 15, the most you’d have to pay is $1,100 if the price of coffee dropped to $0.
If you were selling that coffee, however, you’d still have to buy the coffee at its market rate and sell it back at $1.10 a pound. If a drought hits and coffee soars to $3 or $5 per pound, the most you can sell it for is $1,100.
How To Invest In Commodity Futures
If you want to get into commodities futures but are risk-averse, you may want to ask a financial advisor about indexed funds. Those funds are pegged to the costs of commodities. They contain multiple commodities futures and other assets to diversify holdings and minimize risk.
Buying commodity futures directly requires entering a commodities market with the help of a broker or online brokerage. The latter option holds considerable risk, so think about consulting the National Futures Association broker guides. You will also have to set up a “margin” — a sum of money dedicated to covering losses. Consider what you’re comfortable losing before entering a commodity futures contract.
Commodity futures offer tangible results and huge potential for both price speculators as those hedging against disaster. They’re also volatile and come with extremely high risk for those on the selling end, so approach with caution.
Commodities Futures Tips
- Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Diversification is one of best ways to try and ensure growth within your investment portfolio. This strategy dictates that client assets belong in different parts of the market at the same time. This will help to avoid becoming reliant on a specific investment type for returns. Don’t disregard this. Otherwise, you run the risk of a massive collapse should the market you’re invested in falter.
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