Exposure to real assets can be achieved through commodity futures trading on one of the many global commodity exchanges across the world. There is a long history to the development of the commodity futures contract, and the 21st century markets make use of the latest trading technology to the extent that significantly more trade is now done electronically.
You may have an image of men and women in colorful jackets shouting instructions to each other across the trading floor or perhaps today a more detached view of trading commodities via remote computers across the world, perhaps in an office or even a bedroom at home.
Such is the power of the internet that it can facilitate an electronic trading platform even for small retail investors and traders.
Futures contracts mean a buyer say of orange juice and the plantation owner need never meet each other to do business. Or the cocoa farmer in West Africa need not know the chocolate factory owner who buys futures for delivery of a few tonnes of his quality cocoa beans.
It is the nature of commodities as fungible assets that they can be traded in this way because they are the same so long as they meet strict quality criteria and are traded under standardised contracts.
A commodity futures exchange will set out the criteria on which it will accept a commodity for futures trading. Potential buyers who take physical delivery of commodities from the exchange's warehouse can have confidence that the product conforms with quality standards.
For example, if you are looking to buy Arabica coffee futures you will need to know what is the quality or basis of the bean and whether it trades at a premium or a discount to a benchmark coffee, and this will be partly determined by its origin.
The futures contract can either be executed electronically on one of the numerous electronic trading platforms linked to the major commodity exchanges or by the traditional open outcry method on the floor of the exchange.
The basic form of a futures contract is that it must state a location and date for physical delivery of the particular commodity.
A look at the various commodities will show the delivery months, when for example, crude oil will be delivered in Cushing, Oklahoma or which months physical cocoa is delivered from West Africa or Latin America to US ports such as Baltimore, Hampton Roads or New York.
Futures contracts must also show clearly the standard amount of the commodity being sold or bought. For example, the standard futures contract for ICE Futures US Robusta Coffee is 37,500 pounds.
And if you get into commodity futures trading you will need to be sure about which contract is being traded. For example, if you trade ICE Futures Europe Coal, is it the Rotterdam or Richards Bay contract. Or if you are into crude oil on the same exchange, are you trading ICE Brent, Middle East Sour or WTI Light, sweet?
Payment is an important consideration and this must be settled at the close of business each day. Look how different it is to trading shares where you get settlement after three days.
An interesting point to note in commodity futures trading is that the price at which you will sell or buy the commodities at a future point in time is fixed. Yet the market price of the actual contract will fluctuate according to forces of supply and demand in the market at that time.
So if there was, for example, serious flooding in South African mines which produce platinum, you may see a sudden sharp rise in platinum futures prices in anticipation of falling supplies in the near term, other things being equal.
Another important consideration in commodity futures trading is the concept of leverage. A commodity trader can control a much larger sized contract than she could if using 100% capital. Trading on margin means you may only have to put down between 3 and 10 per cent of the contract size.
This way it is possible to make substantial profits with derivatives such as commodity futures, but equally you can suffer a very large loss of capital. Let's say you go long oil at $45 and the market retreats to $32 a barrel, then you are sitting on a potential loss of $13 a barrel, which for one contract would be $13,000.
If your margin is tested you will get a margin call from your broker asking you to make more funds available to maintain your account margin.
Clearly the leverage or gearing effect in commodity futures trading is exciting if the market moves as you predict, but equally can create huge losses if it moves the other way, truly a double edged sword.
Such risks are inevitable given the structure of derivatives and if you are considering entering the world of commodity futures trading you are strongly advised to seek professional advice from your financial adviser.
William Davies writes for Commodity Trading Today, an informational and educational resource on commodities and markets.
You can get free trading alerts and articles from the Commodity Universe Newsletter at http://www.commodity-trading-today.com/commodity-future-trading.html
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By William Davies
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