The commodities futures market has been described as continuous auction markets. It is a clearinghouse for information about supply and demand. The futures market reflects the cash market.
The difference between futures prices and cash prices at any moment is called the basis. Compared to the stock market the futures markets are exceptionally prone to false breakouts and trends have wilder swings, tempting traders to leave early or enter late, possibly with a loss. Just have a look at commodity futures charts, and compare them with stock market charts. The difference in trading pattern will be apparent.
The futures markets enable buyers and sellers to hedge against, or cushion the impact of, pricing changes. Buyers and sellers set up trades to minimize potential losses from rising and falling prices on spot markets through these hedges in the futures market. The futures market is used to help determine the price for future deliveries. It is used to purchase a contract today to guarantee a future shipment of commodities like coffee and copper.
The commodities futures market attracts speculators due to the nature of rapid changes in price levels as well as the large amount of financial leverage offered on trades. A commodity speculator may be required to deposit only $5,000 to control $100,000 or more of a commodity. This leverage increases the profit potential on trades but as many traders soon find out also increases the risk of loss.
The futures market performs its function of price discovery more rapidly than the stock market. The futures market in the United States has deepened considerably since 1990s. One recent reason for keen interest in the futures markets has been the movement of crude oil contracts. Tremendous fortunes have been made and lost as crude oil moved from $10 a barrel to nearly $150 a barrel over just a few years.
Longer-dated futures prices are also responding more to daily oil market news, suggesting that while market participants are more actively forming views about prospects for supply and demand, their assessment of the likely impact on future prices has become more uncertain. The futures market can take in billions of dollars within minutes, causing the danger of a stock market crash from instability. Many common stock holders may all want to sell simultaneously should a spike in the price of oil continue for long. No doubt money has moved from the stock market to the commodities futures market during the run up in oil and other commodity prices.
Prices are usually expressed in monetary terms. In a free market, prices are set as a result of the interaction of supply and demand in a market. When demand for a product increases and supply remains constant, the price tends to rise. When demand for a product decreases and supply remains constant, the price tends to decline. Prices are an indication of the scarcity of goods and resources.
In the case of oil contracts we have little idea what the real price of oil should be because of massive government intervention and massive speculation, some of which helps keep the price artificially low and some of which drives the price up. Recently huge inflows of funds from hedge funds and the like have driven oil prices sharply higher as fears mount that indeed peak oil is not only real but is already happening. Then you have heavy demand pressures coming from China and India as their economies continue to grow at 8% to 11% a year, year after year.
Contract trading is done for a fixed fee (commission) per contract ranging somewhere between $25 and $100 per contract or even less with Internet trading(in and out). Contracts are created by market demand for the basic commodity. Contracts are standardized according to the quantity, specification, place and date of delivery. Since not all basic commodities can be standardized, there are futures contracts only for the main ones.
Margins are determined on the basis of market risk and contract value. Margins are also referred to as performance bonds. Margin accounts and a process called marking-to-market all but assure the clearinghouse's solvency as the commodity trader gets a daily report on the standing of trading accounts and must immediately fund margin calls or face liquidation of his contracts.
Oil is not really just a dollar story but is a supply/demand story. Oil prices were boosted Friday, June 6th, to record price levels near $140 a barrel by the dollar, which declined sharply against the Euro and Yen. The European Central Bank said it was unlikely to consider interest rate cuts to cool the strong Euro against the slumping dollar. Oil at $135 to $140 a barrel is already doing that a bit , but in Europe some 53% of the cost at the pump is government taxation. It doesn't carry much weight at OPEC when more than half the oppressive cost of fuel amounts to taxation.
Besides OPEC members realize more than anyone that oil is a depleting resource and that one day all that can be pumped out of the ground at reasonable cost will be gone forever. They are going to get as much cash as they can for as long as they can from their oil resources. If you have to have the oil you are going to have to pay up.
Oil is not the only commodity that has been roaring ahead this year. Precious metals are in a major bull market as are corn, wheat, rice, and soybeans. In fact, while the fall in the dollar is part of the commodity futures bull markets story you can not get away from the fact that rapidly developing economies in a number of nations and changes in weather patterns caused by climate change are important factors in driving futures prices.
The commodities futures markets are probably going to roar ahead for quite some time. It is a most interesting market environment but also a dangerous one as nations compete for increasingly scarce natural resources and food supplies. Wars have been fought over far less important matters than having enough food to eat or enough energy to keep your economy functioning.
"Taipan" Greene is a retired forex trader and portfolio manager who worked in Asia for over 20 years. The nickname was acquired in Hong Kong and is now used for a number of financial and Internet business related blogs. One of them is at Commodities Futures