Commodity futures contracts provide various direct and indirect benefits to value chain participants, including investors and traders. One of the main advantages is that futures contracts help determine prices and provide hedge against price risk. For you, as an investor, having an understanding of futures contract prices helps you time your entry and exit and into hedging strategies. Here’s what you need to know about pricing futures contracts.
Futures contracts are basically a derivative contract between two parties to buy or sell an underlying (commodity) on a specific date in the future at a particular price. In other words, you lock in the price of a commodity, say gold today, to take delivery of it at a later date. The price of a futures contract is determined by the market. In other words, it depends on some key factors, including demand and supply of the product, macro and micro economic factors, national and international events, including changes in policy and regulation, currency movements, seasonality of commodities and geopolitical events. The open interest of traders also has an impact on price movement. The futures price of a contract also depends on the spot price of the underlying commodity.
While at the start of the contract, the spot price and the futures price may have a large spread, but as the contract nears delivery, the two prices converge. Now, as a futures trader, you have the option of taking delivery of the underlying commodity or settling in cash at the final settlement price. The difference between the purchase price and this settlement price tells you whether you won or lost.
The final settlement price, also known as the Maturity Date Rate (DDR), is the average of the spot prices of the last trading days when the contract expires. This is the price at which all open positions at the expiration of a futures contract are settled. All futures contracts traded in the country, except energy contracts, are compulsory physical delivery contracts. Which means that unless you want to take physical delivery, it’s best to renew your contract. Note that futures contracts are traded in standardized contracts.
Now, for contracts that expire, the final settlement price is determined by probing the spot prices of the last few days and taking a simple average. This applies to agricultural and non-agricultural futures contracts. However, in the case of energy contracts such as crude oil and natural gas, the final settlement price is based on the overall contract settlement price it reflects. For example, the MCX WTI crude oil contract mirrors the NYMEX WTI crude futures contracts. The reason for benchmarking international prices for contracts involving crude oil or gold is that India is the price taker.
Prices are surveyed from market participants, including investors, traders, brokers, importers and exporters and processors, through centers (exchanges) in different cities.
On the other hand, members’ daily profit or loss is settled using daily settlement prices. The daily settlement price of commodity futures is its closing price on the trading day.