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Tuesday, August 5, 2008

How to trade in Commodity Futures

You as a trader should determine your limits for profit and loss. A dealer should keep limits for the amount and quantity of commodities; both sold and bought.

If the Futures prices for two months are close to the day-to-day price, it is the best time to buy.
If the profit is sure to exceed even one rupee per kilo, sell. If there is a constant loss, do away with the deal even if it is in loss, without waiting much. You can regain the loss later by selling or buying.

A trader who can make the right decisions would make more profit from the Futures market than he would perhaps make from the stock market or real estate deals. While stock market demands at least 50% of the whole value, dealer needs to spend only 6-15 percent as margin money in Futures Market.

If the trader's judgment is good, he can make more money faster because prices tend to change more quickly than real estate or stock prices. On the other hand, bad trading judgment can ruin you.

Futures are highly leveraged investments. The trader puts up a small fraction of the value of the underlying contract (usually 10 percent of less) as margin. The actual value of the contract is only exchanged on those rare occasions when delivery takes place. Moreover the commodity futures investor is not charged interest on the difference between the margin and the full contract value.

Most commodity markets are very broad and liquid. Transactions can be completed quickly, lowering the risk of adverse market moves between the time of the decision to trade and the trade's execution.

There is no clear demarcation regarding the deals. Practically anyone can do any kind of dealings. However, one should take intelligent decisions by evaluating the ups and downs of commodity in the spot market. Normally, as the term period increases Futures value may increase. But this need not happen at all times. As the period decreases the difference in the price in the spot market will decrease too. On the 15th of every month, the ready market price and Futures price should be the same.

Hedgers and Speculators

There are two basic categories of futures participants--hedgers and speculators.

In general, hedgers use futures for protection against adverse future price movements in the underlying cash commodity. The rationale of hedging is based upon the demonstrated tendency of cash prices and futures values to move in tandem.

Hedgers are very often business houses, exporters, traders, farmers or individuals, who at one point or another deal in the underlying cash commodity.

Take, for instance, a major food processor, who trade in pepper. If pepper prices go up he must pay the farmer or pepper dealer more. For protection against higher pepper prices, the processor can "hedge" his risk exposure by buying enough pepper futures contracts to cover the amount of pepper he expects to buy. Since cash and futures prices do tend to move in tandem, the futures position will profit if peppers prices rise enough to offset cash pepper losses.

Speculators are independent traders and investors. Independent traders, also called "locals" trade for their own accounts. For speculators, futures have important advantages over other investments, as we have explained elsewhere.

There are many ways to trade in the futures market

One way is to calculate the approximate production of a commodity and sell it in the commodity market, which will be harvested many months later. The farthest month possible form harvesting would be the best choice.

Assume that the best possibility to get best price is in the farthest month and fix the deal. When the period ends you can bring the goods to the Warehouse, receive the receipt, give it to the dealer and finish the deal.

Now think of a situation that you sold the commodity on the Futures market when you were actually holding it. That is, you sold 2 tonnes of rubber you had, in the Futures market. Then you find the price going down in the Futures market. You can wait for the whole period and can buy back as much rubber as you had sold. This process is called squaring. In addition to the profit in the Futures market you can sell it in the ready market for whichever amount you receive and can gain that profit too.

The next method is that the farmers themselves can do the speculation. Sell the commodity, which is with you in the ready market. You will get ready cash. Then invest some of this amount in the Futures market if the price is rising there. Then you can sell this when the price is high and gain profit.

Another method is similar to this. The farmer sells his commodity in the ready market and gets ready cash and in the same month he buys that much of goods from the Futures market on the day on which the deal ends (15th). Since it is bought on that day's Futures there is no time to square and finish the deal. The goods have to be bought by giving the full price itself. When you spend this money you will get the warehouse receipt. There is 3 months' time to take the goods out of the warehouse. Let the goods remain there. The warehouse receipt is valid for 3 months. You can pledge this legal document or can keep it as a deposit document.

Another way is that, using this you can sell the goods for three months Futures. Since the goods are in the warehouse (warehouse receipt is your proof) you don't have to spend the margin money. When the term ends, you can bring the receipt to the member organization and finish the deal.

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