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Commodity derivatives are investment tools that allow investors to profit from certain items without possessing them. This type of investing dates back to 1848 when the Chicago Board of Trade was established. Initially, the idea behind commodity derivatives was to provide a means of risk protection for farmers. They could promise to sell crops in the future for a pre-arranged price.
Modern commodity derivatives trading is most popular with people outside of the commodities industry. The majority of people who use this investment tool tend to be price speculators. These people usually focus on supply and demand and try to predict whether prices will go up or down. When the prices of a certain commodity move in their favor, they make money. If price moves in the opposite direction, then they lose money.
The buyer of a derivative contract buys the right to exchange a commodity for a certain price at a future date. Although this person is a contract buyer, he may be buying or selling the commodity. He does not have to pay the full value of amount of the commodity that he is investing in. He only needs to pay a small percentage, known as the margin price.
The contract seller is the person who accepts a margin. He agrees that on a certain date he will buy or sell the commodity stated in the contract at a certain price. Both parties are generally required to honor the agreement despite losses.
For example, an investor may buy a contract from the seller that gives him rights to one ton of coffee beans for $1000 US Dollars (USD) on July 1st. Although the value of the contract is $1000 USD, the buyer may only be required to pay $100 USD. On July 1st, the seller will transfer the rights of one ton of coffee beans to the buyer.
If the current value of a ton of coffee beans on July 1st is $1,500 USD, the buyer can sell to the market and make a $500 USD profit. If the value of coffee beans on that day is only $800 USD, this person will have purchased at a loss. He can choose to take possession of the coffee beans, which is rare. He can sell to the market at a loss. In most cases, he will become the seller and attempt to find a buyer.
Commodity derivatives trading allows a person to use a small sum of money for the potential to earn substantial profits. This sort of investment, however, is considered high risk. When prices are not in an investor’s favor, he can suffer substantial losses. Commodities that are open to this type of investing include cotton, soybean, and rice. In some countries, although these commodities are available, this type of trading is illegal.