Trade Crude Oil

When we talk about trading, what comes to your mind? Stock trading? Foreign currencies exchange or commodities?? Have you heard of a form of securities called futures contract? I believe it is not popularly known to the public as we may not hear it as often as other form of trades.

As the name suggests, futures trading is essentially trading something in the future, which has not occurred yet. It is another kind of financial derivatives typically traded in major stockexchange such as Chicago Board of Trade (Part of CME group) and New York Board of Trade (ICE). Sounds too sophiscated to you? Don’t worry here’s an example:

“David is an American farmer who works day and night in his farm. He grows corn. However, the harvest will only sustain him 3 months of living. Then he has to work as a newspaper distributor before the next harvest. He was never close to rich.

One day, due to the nature of his work, David realized that his experience is enough to tell the result of the harvest one month before the actual harvest. His forecast is based on various factors such as changes in climate, volume of rain, availability of adequate fertilizer and also invasion of pests. David the American predicted that the corn harvest would be exceptionally good the next autumn. Very confidently, he approached most farmers in town and entered into agreements to guarantee his purchase of corn at a favorably low price when the harvest was ready. Many other farmers entered into this future agreement with David because no one was certain whether the harvest would be plentiful or poor and all are willing to hedge against the risk of uncertainty of poor yield against a lower price offered to David.

Expectedly, the harvest was good. David managed to close all his contracts by purchasing the corns at a previously agreed price. He now has the control of most of the corn in town, and is able to sell them at any rate he pleased, and make a large return of it. He became rich very soon after the harvest and that has then changed his lifestyle.”

In this example, David the American and other corn farmers are Futures contract traders. The underlying asset of the contract is the harvest of corn. Contract date is the date of harvest in autumn.

Essentially, David foresaw that the harvest will yield a good price; hence he entered into a futures contract with other farmers to trade somewhere in the future, when the actual harvest occurs. At the same time, other farmers were risk adverse, they were fearful of a poor harvest yield; hence they agreed to sell David the corns at a prefixed price to hedge against potential losses. Obviously David was the winner of this contract because of his market insight from experience. The other farmers were not entirely on disadvantage because they are still able to sell their corns at a lower price, which secured them a fixed earning.

Usually, Futures contract is standardized to ensure their liquidity to be traded in say New York Board of Trade. It will have a fixed underlying asset or instrument. This could be anything from corn to a barrel of crude oil to a short term interest rate. Mode of settlement is also fixed, either cash settlement or physical settlement. The amount of underlying asset per contract is also predetermined. This can be the notional amount of bonds, fixed number of barrel of oils, unit of foreign currency or ounce of gold. It is quoted in a fixed currency. The delivery month. The grade of deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content and API specific gravity, as well as the Pricing point– the location where delivery must be made. The delivery month also must be known to traders, the last trading date where trade can be entered, and other details such as commodity tick, the minimum permissible price fluctuation and such. We will go into deeper detail of american futures trading contract in the next article.