What are commodity futures?
Commodity futures are contracts that enable you to buy or sell a set amount of a commodity for a set price on a set day.
At the point of expiry, futures contracts have to be settled in some form – unlike options contracts which can be left unexecuted at expiry. While futures contracts can result in the physical delivery of the asset, most traders choose to settle their position in cash or roll over the trade to the following expiry date.
Futures were originally created to give companies a way of safeguarding their revenue streams against dramatic price fluctuations in materials, but now most futures trading volume comes from hedgers and speculators.
Futures are the most common means of speculating on commodities, as their prices move up or down in line with the underlying asset.
What are commodity spot prices?
A commodity spot price represents the cost of exchanging an asset immediately – or ‘on the spot’. Traditionally when using the spot market, you’d physically take ownership of the commodity you’ve exchanged, but it has become used for speculation and hedging – just like futures.
It’s important to note that since delivery ‘on the spot’ is not possible practically, the seller is given 5-7 days to honour the contract.
It’s also likely that if you want to physically buy a commodity on the spot, there will be additional costs that come with the process of turning the raw material into a useable good. For example, if you wanted to buy spot gold, the price listed is for one ounce of gold, but you’d typically buy gold in bars or coins.
Differences between commodity futures and spot prices
While futures and spot prices are types of purchasing agreements for commodities, they differ in the time and date of execution. A futures contract refers to a deal that’s going to happen at a at a later expiry date, while spot commodity deals are executed immediately.
For example, you can either buy gold in the spot market and take delivery straight away, or you can buy gold in the futures market and decide before the settlement date whether to take delivery or not.
Here’s a more detailed breakdown of the differences between the two:
|When is the contract settled?
|On a specified expiry date
|What strategy is the agreement used for?
|How is the deal settled?
|Physically, in cash or rolled over
|Physically or in cash
|Is there a fixed expiry?
|Are there overnight funding costs?
|Are there rollover charges?
|What is the technical analysis timeframe?
|Charts are only available within the expiry period
|Continuous charting is available
The relationship between the spot price and futures price is described by the terms contango and backwardation. Contango occurs when the futures price is higher than the spot price of the underlying, while backwardation occurs when the futures price is lower than the spot price of the underlying.
Futures prices do tend to trade at a premium to spot prices, due to the cost of carry – the costs a seller has to incur to maintain their holding over the time period. This could include insurance, storage costs and so on.
Example of a commodity trade
Let’s take a look at each type of contract in an example, in which you believe the price of WTI oil is going to rise from the current market price of $65 per barrel.
Scenario one: buying a futures contract
You buy a futures contract for 100 barrels of oil at $70 each, with an expiry for one month.
As the end of the month approaches, the price of WTI has risen to $75 a barrel, and you close your position. Your contract means you can buy 100 barrels of oil at $70 each, rather than the current market price. This means you’ve saved $500 ($5 x 100). If you didn’t want to take ownership of the oil, you’d just settle the position in cash, or sell the contract on to someone else.
However, if the price of WTI had remained the same or fallen, you’d have to close your contract at your chosen price of $70, which could be much higher than the new going rate – meaning you’d make a loss on the position.
Scenario two: buying at the spot price
As you believe the price of WTI is going to rise from its current price of $65, you decide to buy 100 barrels of oil in the spot market. Your trade would be executed immediately, and you’d pay $65,000 to the seller. The vast majority of spot contracts involve the physical delivery of the asset, some brokers will allow you to settle in cash.
At a later date, if the price had risen, you could sell your holding on at the new market price, earning a potential profit.
How to buy commodity futures
Buying commodity futures involves entering a commodity market via a broker, as exchanges can only be accessed by clearing members – these are usually institutions rather than individual traders. Once you’ve entered the futures contract, you’d be obliged to uphold your end of the deal regardless of whether the market price increases or decreases.
Alternatively, you can trade on the price of commodity futures via derivatives such as spread bets and CFDs. You wouldn’t be entering the futures agreement, but rather speculating on whether the price of commodity futures will rise or fall before the date of expiry. Your profit or loss would be determined by the extent to you which you’re correct.
Spread bets and CFDs are leveraged products, so you’ll still only need to put down a fraction of the value of your trade to open a full position. As with standard futures, leverage can magnify your potential profits but does also come with increased risk. However, when you trade via spread bets or CFDs, you can manage your risk via stops and limits, which enable you to set entry and exit points for your trades based on your risk appetite.
How to buy spot commodities
Buying commodity spot is usually also done directly on a commodity exchange, so retail traders and investors will need to execute their transactions via a broker. However, you can also speculate on the price of spot commodities with spread bets and CFDs.
We price our non-expiring commodity markets (spot prices) using two sufficiently liquid futures contracts on the underlying commodity. This is usually the two with the nearest expiry date.
Learn more about our pricing.
Our spot markets have continuous charting, which also means you can also perform technical analysis over much longer timeframes.
How to trade commodity futures and spot prices
You can trade commodities via futures or spot prices in just a few quick steps: