How to profit from commodity futures

How can you make profit from commodity futures.?

This is the question often asked by investors who are trading in commodities futures.

If you are planning an investment in commodity futures, you should understand the different investment strategies involved.

In futures trading, commodities are mainly classified into two, according to the nature of the commodity -- metals and energy and agro commodities. Compared to metals and energy, price movement in agro-commodities is fully influenced by the climatic conditions, supply-demand scenario, government policies etc. But in case of metals and energy, we have also to consider the economic conditions, especially the leading economic builders and geopolitical conditions.

To trade in agro commodities, you should understand their seasonal and off-seasonal movements at national and international levels. You should also know the demand-supply scenario of the agri producing-consuming countries.

Seasonal and off seasonal movements include the supply and demand in the peak season and off-season. Usually in peak season, supply would increase and so price declines. In off-season, supply would decline and hence price increases. Beside this, you need to consider the international demand–supply and seasonal changes because if you take a specific commodity, the production period may be different in various producing countries.

In the case of metals and energy, economic and geopolitical conditions are the main driving factors. Demand and supply, government policies and reserves also can affect the prices alongside. Considering the case of precious metals, depreciation of currency, geopolitical tension and economic recession are the supportive factors.

One of the most useful advantages of commodity futures trading is the better price discovery and minimization of price risk. This ensures efficient price signals, which enable producers to plan their production strategy and stockists to plan their stocks in an effective manner.

Beneficiaries
The beneficiaries of commodity future trading are not only the producers but also the exporters, hedgers, arbitragers and also the speculators. All these participants are the elements of the market. Without any of the elements, the market mechanism will collapse. There is a common misconception that speculators are spoiling the market, but actually they are providing liquidity and direction to the market.

The primary benefits of commodity futures trading include finding the maximum price and minimizing the risk. Since futures trading helps to find the prices of commodities after many months in

advance, the risk of loss is limited.

There are different methods that traders can use to invest in particular commodities safely. They include hedging and arbitrage.

Hedging
In hedging, farmers can sell their agricultural products in advance and ensure profit. By estimating the production, trade can be executed on a price better than the spot price. The rate is likely to be highest for the farthest month future contract. By estimating the supply of a commodity by that month, the trade can be activated.

Stockists, exporters and traders can also use this method. A stockist can hedge his stock with the futures and avoid unexpected price variations. Exporters can use this method effectively and hedge their order book with the same commodity in the futures market.

The actual role of producer is to sell their products into the market. Never change a producer as a buyer. Buyers include stockists, millers, dealers, exporters etc. This is the actual buyer-seller principle in the futures market.

Use of the warehouse receipt is another facility in futures trading for easy transaction and as a collateral security. By taking the commodity to the warehouse within a stipulated time period in the prescribed quantity and quality, the warehouse receipt can be obtained and trade be settled. The warehouse receipt will act as a collateral security, which will make the money supply to producers and stockists.

Optionally, trade may be settled by buying from the future market the equal quantity of the commodity sold earlier.

Arbitrage
Another method to participate in futures market is through arbitrage. Those who possess enough quantity of the commodity can sell it at the best price available in the spot market and collect full price in cash then itself. Using a fraction of that cash, the commodity may be bought and sold from the future market. Profit from the future market transaction would be an additional income.

Arbitrage is also a less risky method of trading. In these case traders can encash the price differences of the same commodity in different exchanges by selling of commodity, which has high price and buying the lower priced; and revise the trade whenever it comes in a common rate or convergences of prices take place.

Speculation
In speculation, trade has no direct relation with the physical commodity one possesses. You execute trades by studying the market and following the price movements. Speculation is mostly intra-day in nature. But speculation is more risky compared to other trading methods.

Biju Thomas is Head, Commodity Online Research.