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Commodity derivatives trading is a rapidly growing financial field in recent years. However, it also requires participants to understand specialized terms to seize opportunities and mitigate risks. In the article below, SFVN will introduce you to the basic terms in commodity derivatives trading, helping you gain more confidence when entering this promising market.

Understand commodity derivatives trading terms to seize opportunities and minimize risks in the market

What is Commodity Derivatives Trading?

Commodity derivatives trading involves the buying and selling of financial contracts based on the value of an underlying commodity such as agricultural products (corn, wheat), energy (crude oil, natural gas), metals (gold, silver), or other financial indices. Instead of trading physical goods, investors trade contracts based on their value. The commodity derivatives market provides investors with effective tools to reduce risk and optimize profits.

Commodity derivatives trading is a financial tool that helps mitigate risk and optimize profit without the need to own physical goods

Basic Terms in Commodity Derivatives Trading

1. Commodity Derivative

A financial instrument based on the value of an underlying commodity (such as oil, gold, agricultural products), allowing for pre-set price trading to hedge price risk or speculate for profit.

2. Derivative Contract

A financial contract with a value derived from the price of an underlying asset, such as commodities, indices, or interest rates. Includes futures and options contracts, allowing commodity trading at a set price in the future.

>>> Read more: Overview of Common Types of Derivative Contracts

3. Forward Contract

A forward contract is similar to a futures contract but is typically traded over-the-counter (OTC) and can have its terms customized according to the needs of the parties involved.

>>> Read more: What is a Forward Contract? Benefits and Applications in Investment

4.  Futures Contract

An agreement to buy or sell a commodity at an agreed quantity and price on a specific date in the future, common with products like oil, gold, and agricultural products.

>>> Read more: What Is A Futures Contract? Comprehensive Guide For Investors

5. Options Contract

A contract granting the buyer the right, but not the obligation, to buy or sell an asset at a predetermined price in the future. There are two types: call options and put options.

>>> Read more: What Is An Options Contract? What Investors Need To Know

6. Swaps Contract

A swaps contract is an agreement between two parties to exchange cash flows or assets, often used for interest rate or currency swaps.

>>> Read more: What is a Swap Contract? Essential Knowledge for Investors

7. Underlying Asset

A specific commodity or asset that underlies a derivative contract, commonly including agricultural products, precious metals, and energy.

8. Margin

The amount of money investors must deposit when trading derivatives to ensure payment capability in case of adverse price movements.

9. Liquidation

Liquidation is the action of closing a contract position before maturity. Through liquidation, investors can avoid risks or lock in profits depending on market conditions.

10. Trading Volume

The total number of contracts bought and sold within a given period, reflecting market activity.

11. Open Price

The first recorded price at the beginning of a trading session. This is an important benchmark price, helping investors assess market trends.

12. Close Price

The last recorded price at the end of a trading session. This price is often used to analyze and forecast the next day's trend.

13. Leverage

A tool that allows investors to trade with a larger amount of capital than they actually own. Leverage can optimize profits but also comes with high risk.

14. Strike Price

The pre-agreed price in an options contract, used to buy or sell the underlying asset at expiration. This price allows investors to know in advance how much they will pay or receive when exercising the option.

15. Expiration Date

The last date on which a derivative contract remains valid. After this date, the contract is settled or becomes worthless, depending on the contract type.

16. Spread

The difference between the buy and sell price of an asset. In derivatives trading, the spread impacts transaction costs and investor profits.

17. Contango

Contango occurs when the futures contract price is higher than the current price of the underlying asset, often seen when the market expects commodity prices to rise.

18. Backwardation 

Backwardation is when the futures contract price is lower than the current price of the underlying asset, usually occurring when short-term demand is high.

19. Basis

The difference between the spot price of the underlying asset and the futures contract price, helping to assess the relationship between these two markets.

20. Hedging

A technique using derivative contracts to reduce price risk, protecting asset value against market fluctuations.

21. Speculation

A strategy seeking profits from price fluctuations in derivatives, often associated with higher risk but also substantial profit potential.

22. Mark to Market

Valuing a contract based on the end-of-day market price to determine actual profits or losses.

23. Long Position

A position expecting commodity prices to rise, where the investor buys a derivative contract to benefit from the price increase.

24. Short Position

A position expecting commodity prices to fall, where the investor sells a derivative contract to benefit from the price decline.

25. Open Interest

The total number of open derivative contracts, reflecting market activity and trends.

26. Margin Call

A requirement to deposit additional margin when the contract value decreases, preventing the position from being automatically liquidated.

27. Contract Size

The quantity of commodity in a derivative contract, aiding in the calculation of costs and profits.

28. Roll Over

Transferring an expiring contract to a longer-term one to maintain an investment position.

29. Spot Price

The current price of a commodity on the market, differing from the futures price as it excludes storage costs.

30. Notional Value

The total value of the underlying asset in a derivative contract, helping to assess contract size and risk.

31. Initial Margin

The minimum amount an investor must deposit to open a position in a derivative contract.

32. Maintenance Margin

The minimum margin that must be maintained to keep an open position; if it falls below, a Margin Call will be triggered.

Understanding derivatives terminology helps you maximize market potential

Conclusion

Commodity derivatives trading offers great opportunities for asset protection and growth when investors understand the associated terms and strategies. For individuals and businesses looking to capitalize on the derivatives market, understanding tools like futures contracts, forward contracts, options, and swaps is essential.

To start your safe and efficient journey in commodity derivatives trading, register a trading account at SFVN today!