Commodity trading basics

Commodities are traded on exchanges and over-the-counter (OTC). Commodities and commodity based derivatives that are traded on exchanges must adhere to strict rules regarding standardization, e.g. when it comes to quantity, quality and delivery date. Trades that take place outside exchanges (OTC) can be tailor-made to suit the involved parties.

A big part of the commodity trading market consists of derivatives based on commodities, e.g. commodity options and commodity futures contracts. It is very common for these contracts to be cancelled out or cash-settled instead of someone actually taking delivery of the underlying commodity. Commodity derivatives are not only used for speculative purposes; they are also very important for companies that need to hedge their future commodity costs in order to plan their business year.

Traded commodities

Below, you will find a few examples of commonly traded commodities. Most of these are also common as underlying assets for commodity derivatives, such as futures contracts and options.

Type Commodity
Livestock and meat Pork bellies

Lean Hogs

Feeder cattle

Live cattle

Agricultural commodities Sugar

Wheat

Corn

Coffee

Cocoa

Cotton

Soybeans

Metals Gold

Silver

Platinum

Palladium

Copper

Zinc

Lead

Molybdenum

Aluminium

Steel

Energy Crude oil

Heating oil

Natural gas

Gasoline

Price movements on the commodity markets

Price movements on the commodity markets are strongly impacted by supply and demand, but speculation and speculative acts (such as attempts to corner the market) can also have a major influence on prices, especially short-term.

Social unrest can impact the price of a commodity by restricting its supply. If the area around a major mine is subjected to revolution, war, prolonged strikes or any other social upheaval, it can translate into lower production. In some cases, production itself is not impacted by much, but getting the metal from mine to market poses a problem. Both situations can cause a price hike due to decreased supply.

Agricultural commodities tend to be sensitive to weather in the producing regions. Coffee beans being harmed by a sudden frost in major coffee producing areas can cause a spike in coffee bean prices, while beneficial weather can cause the price of coffee beans to drop due to a larger supply than normally being available.

Livestock and meat commodities can be indirectly impacted by price movements on the agricultural commodity markets, e.g. when soybeans are utilized as cattle feed. Disease, health scares and new legalization regarding animal husbandry are other examples of factors that can impact the price of livestock and meat.

Global developments and technological advances can also have short-term and long-term effects on the price of commodities. If alternative energy sources becomes more interesting than crude oil, e.g. due to new technology, increased environmental concerns and tax-funded subsidies, it can make the price of crude oil drop. If major automotive manufacturers need more platinum and palladium to lower emissions, it can cause a price rally for such metals.

Using commodity derivatives for hedging

Historically, the price of agricultural produce and livestock has gone up and down, depending on supply and demand. For farmers that relied on selling their produce rather than just consuming it themselves, the fluctuations made it difficult to plan their economy. On the other side, companies that needed agricultural products for their business were also finding it difficult to plan ahead since they never new how much they would have to pay for the wheat, the coffee, and so on.

This is why commodity forwards and commodity futures contracts became so popular.

Forward contracts

A forward contract has two parties. One of the parties agree to sell a certain amount of a certain product for a certain price (the forward price) on a certain day in the future (the delivery date). The other party agree to buy that amount of the specified product for the specified price on the specified day. Both parties are thus obliged to carry out this transaction. The seller gets peace of mind, because she knows exactly how much she will be paid for her produce. The buyer gets peace of mind, because he knows exactly how much he will be required to pay for the produce. Both of them can now plan their businesses accordingly.

Futures contracts

A futures contract is simply a standardized forward contract. The standardization makes it more suitable for trading, both on exchanges and OTC. The earliest futures contracts all had commodities as their underlying assets. It was until later that assets such as crude oil, stocks and currency began to be traded using futures contracts.

Buying shares in a commodity company

Instead of owning an actual commodity or a commodity-based derivative, some investors that wish to gain exposure to the commodity market invest in commodity companies, e.g. a copper mine or an agricultural enterprise that grows soybeans.

Generally speaking, the stock market is less volatile than the commodity futures market, especially if you stick to well-established stock companies. This is a positive thing for some investors and a negative aspect for others. Someone who is into day trading might for instance appreciate the rapid swings of the futures market, while someone who wish to make long-term investments might prefer to seek out long-term trends within the commodity world and invest in stock companies accordingly.

Investing in companies instead of investing directly in commodities or commodity-based derivatives comes with its own set of issues. A mismanaged agricultural enterprise can for instance drop in value even as soybean and wheat prices are going up on the commodity market. Political instability in the area where a specific copper mine is located can impact its output and stock market valuation, even when the decreased output isn’t large enough to impact the global zinc price. Unfavorable weather can diminish a coffee harvest for a stock company focused on Central American beans, causing the share price to drop even as the global coffee bean price is rising due to diminished supply.

It should also be noted that many commodity companies use hedging to shelter themselves from rapid swings in commodity prices. That means that even if the price of coffee beans are rising right now, the company you invested in might not profit from the increase since they hedged this harvest 1,5 years in advance.