What is a Futures Trade?
Most of the time, hedging a commodity involves entering into a futures contract on a relevant exchange. A futures contract is when you agree to buy or sell a specified tonnage of a commodity at an agreed price at a specific date in the future. This date could be as soon as the next day (‘tom’), two days (‘cash)’, weeks, months, or in some cases even years in the future. In the case of metals, the date on which the futures contract settles is called the prompt date.
A futures contract is not an indication of where prices are going to be at the time of settlement. For example, the most common futures contract traded on the LME is the three-month (3M) contract - this is the price you have most likely seen flashing up on the screen. If the 3M price for copper is $8600/mt, that is not saying that the price will be $8600/mt in three months. It is simply the price at which, given all of the information market participants have at that moment, they are willing to buy or sell copper futures, for a trade with a prompt date of three months from the date of execution. Metal prices are rarely valid for more than a few seconds, let alone weeks or months.
This is something to keep in mind if you find yourself fixing the price of a contract with a customer using screen prices…always confirm a price is still valid with your broker before confirming with your counterparty, otherwise, you will be at risk of the price changing before you can lock in your hedge. As many have found out the hard way, a lot can change in a few seconds, particularly on metals.
Not every commodity can be hedged in this way. To hedge accurately, the commodity you physically transact in needs to have a tradable futures contract on an exchange you can access and that is liquid enough for the volume you physically buy or sell. The price of the commodity you trade in also must be highly correlated to the price set by the exchange. There are plenty of commodities where the price is set exclusively by the companies that trade it or by a publication, not on an exchange. In these instances, hedging using futures contracts is not possible. The companies that trade them will either try to fix the price of their purchases and sales at the same time (often referred to as a back-to-back business), or they will hope the price goes up after they buy (going long) or vice versa when they sell (going short).
