Commodity Futures Basics

Commodities are interchangeable economic goods like corn, wheat, rice, crude oil, and gold.

Each commodity must meet the minimum quality requirements to minimize differentiation between products. This is done to ensure that buyers get the same product regardless of where it was produced.

What is commodity trading

Obviously there is a lot of demand for commodities, but this demand is usually from governments or large corporations. The average investor does not need several tons of unprocessed crude oil sitting on his/her backyard, so why trade commodities at all?

The answer to this question lies within the constant companion of the commodities market, futures trading; this is the process of purchasing commodities at its current price even when the product will be delivered at a much later date.

A lot of commodity traders don’t actually need the products that they purchase, only holding on to a futures contract until the price of the commodity increases and then subsequently selling the contract.

Commodity futures trading may seem like a modern conception, but this practice started thousands of years ago. While most records of these trades were lost in time, detailed records of futures trading in 17th century Japan are still intact.

The commodity market in ancient Japan was the result of agricultural development. With the production of rice rapidly outpacing its consumption, merchants had to store the commodity in warehouses. As a way of making money while their product stayed in storage, merchants started to sell tickets that can be used to redeem rice at a future date. For the consumers, this was a stabilizing force in the market. Conflict was abundant during those times and battles could wreak havoc on farmlands, subsequently causing the price of rice to spike. Purchasing rice tickets at times of peace could ensure that consumers have access to their staple food even should the worst happen.

Over time, trading futures in commodities developed in markets all over the world. In the U.S., futures contracts were made to simplify transactions because prices constantly shifted for perishable goods in the short period of time from storage to delivery. A forward contract gets rid of all the complexities involved with pricing by setting a fixed price for the commodity right from the get-go.



Commodity Futures Basics

Commodity trading is a multilayered market filled with traders of all kinds. Generally though, commodity traders can be categorized into two distinct profiles:

Hedgers

Farmer, miners, manufacturers, and corporations fit into this profile. Hedgers are traders who buy and sell commodities out of necessity; farmers and miners need to sell their goods while manufacturers need to buy raw materials. They’re called hedgers because they use forward contracts to hedge their risk, or in simpler terms, they minimize their risks through the use of futures trading. By using forward contracts, hedgers can buy and sell commodities at a set price instead of putting their faith in the ever fluctuating commodities market.

Speculators

Price fluctuation is a positive thing for speculators because these kinds of traders don’t actually want to own commodities, instead they want to sell futures contracts at a profit. This means that speculators want significant price fluctuations so that their analyses may bear fruit. Such traders pay close attention to the global news, using political and socioeconomic information to predict which commodities gain increased demand in the future.

Types of Commodities

Commodities are generally divided into two types:

Hard Commodities

These are natural resources that require mining or drilling, like: gold, silver, oil, and copper. These commodities tend to have long shelf lives which means they can be stored for a long period time. Hard commodities are also used as a baseline for the health of the global economy due to the reliance of most economic sectors in these goods. Hard commodities are also relatively stable due to the consistency of mining and drilling operations.

Soft Commodities

These are mostly agricultural products like: wheat, rice, coffee, corn, pork, and sugar. Due to the nature of farming and how it is under the mercy of the weather, soft commodities tend to be more volatile. Unpredictable forces of nature have caused significant price fluctuations in the past and will continue to do so in the future. Overproduction of various crops is also a common occurrence, driving down the price of certain crops until the supply is brought down to normal levels.

Aside from the above categories, commodities can be further divided into asset classes. Under the asset class of energy, we have commodities that provide power to cities and vehicles, like: crude oil, uranium, gasoline, and natural gas.

The agricultural asset class contains the various crops and food staples like: wheat, rice, oats, and soybeans. The commodities market can find its roots in this asset class, and for over 100 years, futures trading was based mainly on agricultural products.

Under the precious metals asset class is gold, which played a major part in the history of finance, with the printing of currency being limited by gold reserves in the past. Although gold is no longer as vital to the economy as it once was, it still remains as one of the most stable commodities in the market.

Just because copper, steel and, aluminum are also metals, don’t presume that they belong to the same asset class as gold, silver, and platinum. Metals that are commonly used for construction and production fall in the asset class of industrial metals.

There are a lot more categories in the commodities market, which isn’t a surprise, with human needs and wants bordering on the limitless. With such a comprehensive list of commodities, it’s important for a trader to take his/her time to research. Every commodity has its own patterns; even commodities in the same asset class may react differently to the same stimulus. As with all markets, due diligence is necessary for a trader to be successful in the commodities market.

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