Investment and Trading in Commodity Derivatives

Hundred years back, farmers had to suffer the risk of their crop value going below the cost price of their yield. Commodity derivatives trading had a humble start, initially offered on various agricultural products such as pepper, wheat, coffee, rice and cotton.

Commodity derivatives market is a direct form of investing in commodities rather than investing in those companies trading in such commodities. For instance, an investor can directly invest in steel derivatives rather than investing in the shares of a steel company. It is quite simpler to predict the price of commodities depending on their supply and demand forecast, in comparison to forecasting the price of the shares of the firm. This depends on many other factors before considering just the supply and demand of the products manufactured and sold or traded.

Advantages of Trading in Derivatives:

It is much cheaper to trade in derivatives, since investors require only a small amount of money to purchase derivative contract.

Before looking into how the investment in the derivative contract works, investors need to familiarize themselves with the terms, seller and buyer of the derivative contract. Buyers of derivative contract are those people who pay an initial margin, to purchase the right of selling or purchasing a commodity, at certain date and at certain price in the future.

The sellers, on the other hand, accept the margin and agree to accomplish the decided contract terms, by selling or buying the commodity at a fixed price on the contract maturity.

The answer to actually how the investment in the derivative contract works is as follows. The individual investor has the option of taking the delivery of one ton of soybean and selling it in the market for a higher cost making a hefty profit. On the contrary, in case, the price of soybean falls to 8400, the investor makes a hefty loss.

Rather than the investors taking the commodity delivery on contract maturity, they also have an option of settling the contract in cash. Cash settlement includes exchange of the spot price difference of the exercise price and the commodity, depending on the future contracts.

Overview:

Settlement and clearing of trades is the most critical function in the commodity derivatives exchange. Commodity derivatives also involve the exchange of goods and funds. For handling all settlements, the exchanges have a separate body known as clearing house.

For instance, the seller of future who contracts to purchase soybean, can select to take the soybean delivery prior to maturity as compared to closing the position. In such cases, the function of the clearing organization is, to take care of the possible default problems created by the other party being involved, by simplifying and standardizing the transaction process between organization and participants.

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