Commodities and a Futures Contract – How Are They Different?

A commodity is a physical product that you can touch or feel, such as corn, gold or crude oil.

A futures contract is a commodity that trades on a futures exchange in a standard contract size for delivery at a future date.

The concept of “future” is what throws most people off. It really means that some entity wants to buy or sell the commodity at some time in the future at a price agreed upon today. Remember, futures contracts were created for those with a commercial interest – not speculators like you and me.

How Does a Futures Contract Work?

A buyer and seller create a futures contract. It will consist of a standardized contract of a commodity established by a futures exchange. It will consist of:

• The commodity
• Date to deliver the commodity
• Amount of commodity
• Price of the commodity

For example, Gold Mining, Inc. wants to sell 100 ounces of gold they will have mined by August. XYZ Jewelry Makers wants to buy 100 ounces of gold to make gold rings that they will start manufacturing in September. Since it is currently just March, there is plenty of time where the price of gold could move much higher or lower.

If Gold Mining waits until August to sell their 100 ounces of gold, they run the risk of the price dropping – thus hurt their profits. Oppositely, if XYZ Jewelry Makers waits to buy their needed gold, they run the risk of paying a higher price-thus hurting their profit margins.

This is why both parties create a futures contract – to hedge their risk on the price of gold and to ensure a sale or delivery of gold. One of the most attractive features is that they can close a contract anytime they want during market hours. In fact, less than 5% of futures contracts are held until delivery.

Here is how a futures contract would work in this situation.

Gold Mining sells 1 August Gold futures contract at $625 per ounce. XYZ Jewelry Makers buys 1 August Gold futures contract at $625 per ounce.

The futures contracts are traded on the New York Mercantile Exchange (NYMEX) and consist of 100 ounces of gold. Delivery of the 100 ounces is to be made in August. These two parties are not necessarily making a futures contract with each other. Some other entity could be on the other side of the trade.

If either party decides they no longer need the futures contract for their business needs, they will buy or sell in the open market to close their position and either a speculator or a commercial will take the other side of the trade. If XYZ bought their contract at $625 and sold at $640 two month later, they would make $15 per ounce or $1,500 on their futures contract.

If they both hold until the contract expires in August, XYZ will take delivery of 100 ounces of gold and pay $625 per ounce, while Gold Mining delivers 100 ounces of gold and gets paid $625 per ounce.

So, in this example, gold is the commodity and the futures contract is the means by which gold is traded.