When trading commodity future markets it is essential to know the difference between actual cash prices vs. future markets prices. The future markets prices are what you see in the NYMEX/COMEX. It is what the particular commodity is trading at in the future. Cash prices are what the actual commodity is going for at a certain price in the real market. For example, a plumber has copper inventory stored for use in his plumbing business. There is a certain cash price for his copper that may be higher or lower than what the futures market might be going for. The futures market was established for this type of user so that he can hedge himself against the price fluctuations of his inventory of copper.
Say this particular plumber has a big time business and stores a huge amount of copper in a warehouse. There is a specific cash price that this farmer has paid for all of the copper. Over time the price of copper is going to increase or decrease depending on supply and demand. If the price of his copper increases that will be beneficial to him because now he can go out and charge a higher price to his customers for the work that is done. The plumber paid around $1.37 per 25,000 pounds of copper and now the cash price has increased to $1.45. He is going to be making 8 cents on his initial investment on top of the billing of the work that he puts out. But what happens if the price of copper falls? Now the price of copper is trading $1.30 and he loses 7 cents. His business won’t be profitable because the money he makes doing the plumbing won’t even offset the loss he has suffered with the cash price.
The futures market is essential for the plumber to do his business because now he can hedge the actual copper that he owns by taking an opposite futures side. The plumber hedges with a short position in the futures market so now if the price of copper goes down he will have covered his actual losses with gains on the short. The hedges aren’t always perfect as some might come out with a minor loss or a minor gain. The fact of the matter is that the plumber can still operate his business even if the price of copper should happen to fall.
Trading in futures and options involves a substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future results.
