Commodity trading for beginners

Examples of commonly traded commodities:

  • Agricultural commodities, such as cotton, sugar, coffee, cocoa, corn, wheat and soybeans.
  • Livestock and meat commodities, such as pork bellies, lean hogs, live cattle and feeder cattle.
  • Metals, such as gold, silver, platinum and palladium.
  • Energy, such as crude oil, natural gas, heating oil and gasoline.

Commodities are traded both on and off exchanges. Exchange trading will often required a high degree of standardization, both when it comes to parcel sizes and the standard of the commodity. Traders must have enough confidence in the commodities to be willing to buy them without doing their own inspection. While many stock exchanges have several hundred listed stocks, commodity exchanges tend to only list one or a few commodities.

Commodities can be purchased both as an investment by investor that predicts that the commodity price will go up and by producers who want to hedge themselves against future price fluctuations. Investing in commodities can be very profitable for an investor and it can be absolutely vital for a company to be able to hedge themselves against unexpected price fluctuations.

Prices

Commodity prices largely depend on supply and demand, but speculation can sometimes cause sudden and unpredictable price changes.

When it comes to supply, many commodities are sensitive to factors such as weather and logistics. The political situation and stability in the producing region will also be of importance. For livestock and produce, disease and health scares can have a huge impact on both supply and demand.

Global developments and technological advances can impact both supply and demand of commodities. Increased building in China did for instance create a higher demand for steel that was noticeable world-wide.

Futures & Hedging

Futures contracts (commonly referred to as futures) is a standardized forward contract. The standardization makes it suitable for trading between other parties than the two initial parties to the contract. The two initial parties agree to buy and sell, respectively, an asset for a price agreed upon when the contract is created (the forward price) with delivery and payment occurring not now but at a certain point in the future (delivery date).

Futures contracts are a derivative products, and the very first futures contracts where created with commodities as their underlying assets. The first futures contracts had agricultural commodities as underlyings, and then natural resources such as crude oil followed in suit. It wasn’t until the 1970s that futures contracts with stocks, currency and interest rates were invented.

Using futures contracts for hedging (a type of risk management) is very common among companies that rely on commodities for their business. An airline can for instance use futures contracts with airline fuel as the underlying to lock-in the price of a future fuel purchase. Futures contracts makes it easier for companies to plan their expenses and their bottom line becomes less exposed to price volatility on the commodity market.

On the seller-side, futures contracts can also be beneficial for those who want to achieve a higher degree of economic predictability. A farmer can for instance use futures contracts to lock in a future profit, instead of having to wait and see what the commodity market will be willing to pay at harvest time.

Background

Commodity markets have existed for thousands of years and historic findings suggest that tradeable rice futures contracts existed in China 4,000 B.C. In Japan, the Dōjima Rice Exchange was founded in the 1730s – a thriving futures exchange where the underlying commodity was rice. The exchange was promoted by the samurai, who received their payments in rice.

The name futures contracts was coined in 1864, when The Chicago Board of Trade (CBOT) listed standardized forward contracts. These early futures contracts had grain as underlyings.