As we have already said, commodity trading is based on the principle of trading “termed” futures contracts. This means that they expire on a certain date in the future (and the commodity is physically delivered on this date). We have also explained that we can sell the purchased futures contract anytime before the expiration date. As traders we can profit on this principle. Take the example of corn with delivery in December next year. As a participant in this market you can buy corn futures contract consisting of a clearly defined amount of corn (about 127 metric tons) in the required quality at the agreed price and with delivery in December of the next year. Paradoxically, in this way you can buy 127 tons of corn which has not grown yet (and you already know its price)! On the basis of this futures contract (a contractual relationship) the supplier is obliged to deliver you the above-mentioned quantity of corn in December of the next year. But you already know that you will actually not be obliged to accept these 127 metric tons of corn in December next year because you can sell the futures contract any time and profit on increases of its price.
But what actually led to creation of such a mechanism? Why would someone be interested in buying corn that has not been grown yet? And conversely, who would be interested in selling a non-existent corn? We can find answers to these questions when we look into the history of commodity futures contracts. The first ever recorded mention of commodity futures contracts relates to Japan, to approximately the 17th century. The Japanese growers´ basic need was to secure the necessary finance for seasonal rice cultivation. They needed some initial capital to ensure production. Regarding rice cultivation it is the capital for covering the cost of seed, wages for employees, harvest, product quality control, etc.
The problem, however, was that banks were not willing to lend money for rice cultivation. You surely know from your own experience that every bank wants guarantees that it will get its lent money back (together with an appropriate interest). Thus, if a farmer did not have the sufficient capital for rice cultivation, he could sell the yet-ungrown rice. By doing so the farmer took some risk and assumed that he would be able to grow, for example, 500 tons of rice of a certain quality. The buyer who, for example, produced rice rolls knew that he would need just these 500 tons of rice in December of the next year. Thus the two entered into an agreement (futures contract) that in December of the next year the farmer would deliver the rice-roll producer 500 tons of rice for an agreed price and at the required quality. The farmer obviously knew very well at what price he could sell the rice because he knew the cost structure of cultivating a certain amount of rice. As they say “You don´t get something for nothing”, so the farmer of course added a proper profit.
Surely you already begin to understand the underlying motivation of both the farmer and the buyer of his production for entering into this form of agreement. It is a certain mutual guarantee, which is the essence of the relationship called a futures contract these days. The farmer could be very happy – he had a buyer before he even sowed the first seed. So now he could go to his bank with a signed futures contract and borrow capital for cultivating rice. Or maybe he even did not need the bank. The trader, on the other hand, knew in advance what rice-roll related costs he would have in the next year.
But as they say: “There are always two sides of the coin.” Over time it began to be clear that concluding futures contracts in this form is not always really favourable for both sides. Imagine a situation that the following year, when the farmer grew rice for the pre-agreed customer, there was an extreme crop failure in Japan. Thus, the price of rice skyrocketed. The farmer was surely very frustrated because he was obliged to sell his 500 tons of rice to the rice-roll producer for the pre-agreed price. The producer, on the other hand, was happy because he bought rice for a price that was much lower than the market price. A logical consequence of such situations was the idea of trading with futures contracts and speculating on future commodity prices (rice in our case).
Let´s imagine a situation that the farmer knows that due to a bad weather during the year the harvest will be poor and the price of rice is very likely to significantly rise. The farmer therefore decides to sell a futures contract to another farmer with due profit. The second farmer´s motivation to buy the futures contract may be, for example, to avoid the need to borrow money from the bank to finance the production of his own rice.
Now, Let´s put ourselves in the position of the producer of rice rolls. He could also foresee that the price of rice was going to rise. Therefore he speculated and bought more futures contracts than he actually needed. Now he can sell these contracts to other rice processors with profit. The rice-roll producer himself keeps only the amount of futures contracts that he needs for his own production. Many people very soon realised that futures contracts may be a perfect way to get rich. The imaginary rice market started to have new participants – people called traders or speculators in modern terminology. These people were buying commodity futures contracts if they assumed that the next year there would be a bad harvest and thus they would be to sell their contracts for a higher price, i.e. with some profit. Yet if their assumption of bad harvests failed and there was a rice surplus, these speculators would sell their futures contracts at a loss.
So how you can see, the primary historical purpose of futures contracts was hedging of risk. Producers are motivated to sell futures contracts and buyers to buy them. These basic motivations led to the creation of a central location (exchange) which regulated and facilitated bulk purchases and sales of commodity futures contracts. The point is that if there are many producers and buyers in one place, they can compete with each other which leads to establishing of a balanced price reflecting current market trends. Yet a problem arises when there are few producers and buyers in the market and thus there is an insufficient supply and demand for commodity futures contracts.
This is where we, traders, start to play an important role. The more participants a commodity exchange has, the higher supply and demand there is and the better buy and sell opportunities for a price acceptable for all participants there are. In other words: Traders provide the sufficient liquidity to markets. The more liquid a market is (i.e. the more participants trading with the most contracts it has), the higher chance for all market participants, including producers and processors, that they will be able to sell or buy futures contracts for the desired price.
We, traders (speculators) play a role of mediators in futures exchanges as we can first buy and then sell or, on the contrary, first sell and then buy futures contracts. In the first case our aim is to buy cheaply before a price increase and then to sell the contract and generate profit. In trading terms this is the long position, or “Long”. In the second case we want to sell the contract first for a higher price (like we were for example in the role of a coal-producing company concluding a contract to supply coal) and to close the position by buying the contract back for the lowest price possible (as would do a heating company that buys coal). The trading terminology calls this the short position, or “Short”.
Yes, it is indeed so. On commodity markets, you can earn a lot of money also when the prices are falling!
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