Commodity Markets

Commodities as stores of wealth predate even money. Prior to currency, instruments exchanged as a store of value of goods, and exchangeable for goods, people exchanged goods of value, including generic ones such as livestock or grains that we now understand as commodities.

The first form of money, gold and silver, are of course commodities in themselves, and people would trade these commodities for various things, including other commodities.

Commodity markets are set up to facilitate the exchange of commodities for other things, nowadays consisting of trades of commodities for currency.

The first known commodity market dates back to the 5th century B.C. The Sumer civilization, located in what is today within the borders of Iraq, were known to not only have a commodity market, but a system of what resembles futures contracts.

Clay tokens were used to denote the number of goats that the futures contract involved, and the delivery date, which became replaced with writing on clay tablets once writing was developed. This no doubt assisted both the producers and the buyers in managing their farms.

Commodity MarketsThe same principle exists today, although instead of clay tablets, we use computers to track these trades, and market participants aren’t just limited to people who visit the market, as today’s markets are electronic and can be accessed by anyone with a trading account associated with the commodities market.

While the spot market for commodities has always been significant, futures contracts also played a prominent role in the function of these markets, where the goal of standardizing these contracts forms a main function of commodity markets.

In the Middle Ages, commodity markets were further developed in Europe, which eventually led to the world’s first financial exchange being built in the 16th century, in Amsterdam, which was initially a commodity market.

By this time, commodity contracts were already well developed, and the Amsterdam Stock Exchange not only offered futures contracts, it also offered futures options as well as allowing for short selling of contracts.

The Chicago Board of Trade was the first major commodities market in the United States, which led to Chicago eventually becoming the world capital of commodities. Its closer location to the agricultural areas of the country made the city a natural choice for commodities, and the CBOT took futures and options to a whole new level of market participation.

Today’s Commodity Markets

The CBOT is now part of the CME Group, along with the Chicago Mercantile Exchange, who they merged with in 2007. The CME Group is the world’s largest commodity market, with 16 million contracts being traded on average each and every market day.

There are over two dozen different commodity exchanges located throughout the world. While most trade contracts on agricultural commodities, one may buy contracts for other commodities, such as precious metals or energy products such as crude oil.

The old-fashioned method of open outcry is still used to some degree in commodity markets, in what is called the pits. Orders are sent to the trading floor where they are executed by floor brokers through a combination of verbal and hand signaling.

This system predates computers or even the telephone, although for years the phone as well as pen and paper were the tools of the trade in the industry on the floor. In spite of the open outcry method of trading being well outdated, it still exists, although a lot of commodity trading is done fully electronically these days as well.

Floor brokers don’t just have to rely on their notepads anymore although they are still used to an extent. Where it used to take quite a while to execute a trade in commodities exchanges, nowadays technology has sped this up quite a bit, even with trades that use the old-fashioned way.

Faster executions are always better, and overall, over the past few decades, execution time has really sped up over how long it used to take in the old days. A lot of people trade futures and have come to expect very fast executions of their orders, and commodity markets have kept up pretty well with this.

The biggest change with today’s commodity trading is that orders can be placed from anywhere on a computer, instead of actually having to be at the exchange in the earliest days of commodity exchanges, or having to phone your broker who would then use the phone to place the order prior to electronic trading.

Types of Commodity Trading in Financial Markets

The financial market is no longer confined to a physical location, or just one exchange, and when one trades in commodities, this can involve multiple products across a number of exchanges.

Commodities exchanges themselves deal in futures and options contracts, although not all exchanges offer the full selection of commodities that are traded. Depending on the type of commodity you are looking to trade in, your order may be placed in one exchange or another, depending on where it is offered.

There are also different types of a certain commodity, such as West Texas Intermediate crude and Brent Crude. The Intercontinental Exchange offers contracts for both, while the NYMEX only offers WTI crude contracts.

When you place an order for a futures contract, you don’t have to worry about any of this, as this is what brokerages are for, to route your order to wherever it needs to go in order to have it filled.

Forward contracts are futures contracts that do not occur on an exchange, they instead are offered directly on the over the counter market. These trades are completely electronic, one computer to another without an intermediary exchange facilitating it.

Futures contracts offer the benefit of being tightly regulated by the exchanges that they are traded on, while forward contracts are private contracts between two parties to exchange commodities on agreed upon terms in the future.

Futures options are a contract which gives the right to enter into a contract for futures. They operate much like other options, although given the additional risk of trading futures combined with the additional risk of trading options, futures options are certainly riskier than just about any other form of trading.

Exchange traded commodities, or ETCs, are a security that trades like a stock which tracks an individual commodity or a basket of commodities. These securities are similar to exchange traded funds, or ETFs, other than the fact that ETCs are pure commodities, whereas commodity ETFs have a lot more flexibility, and may consist of a number of commodity assets in addition to the commodities themselves.

Some ETFs track certain commodities without ever owning the physical asset, like gold ETFs for example. You can then benefit from fluctuations in the commodity.

Contracts for difference got their start from the futures market, where instead of having to take ownership of a commodity at the expiration of the futures contract, the difference in price between the spot price and the contract price was exchanged. Nowadays, most contracts simply roll over, which doesn’t require any settlement unless one wishes to.

Contracts for difference have expanded to much more than the futures market, and one may trade these contracts through a broker, taking positions in a wide variety of instruments and paying or collecting from the broker the difference in price resulting from the trade. Many people trade commodities this way instead of buying and selling the future contracts directly.

With contracts for difference, the broker who the contract is with may or may not cover their position in the market. Unless one has proven themselves as a good trader, it’s better for them not to, as in this case they make not only the extra spread they add, but the entire loss of the trader.

If a trader does know what they are doing though, then the broker will lose when the trader wins, so they do tend to cover these in the market.

The Future of Commodity Markets

In a real sense, the future is now where commodity markets are concerned. It is likely though that at some point in the near future we’ll see the trading floors disappear in favor of fully electronic commodity trading.

Commodity markets are already pretty liquid, but as more and more people become acquainted with these markets, we may see even more liquidity. Futures trading does not seem to be as accessible to a lot of traders as other markets seem to be, but a lot of this is just a matter of the lack of familiarity that a lot of individual traders have with the commodity market.

A lot of people think that you need special knowledge to do well with commodities, either about the commodities themselves or with the markets, but it’s all a matter of trading charts. It certainly can be helpful to be familiar with the price movement of a commodity, but that’s true of any instrument you are looking to trade, and for the most part all financial trading is similar in nature, it’s all just price and volume data really.

While primary participants, banks and governments in this case, simply dwarf speculators in the forex market, in the case of commodities, speculators have become a major force in the market. As the word gets out more about commodities trading and it becomes more and more accepted, this trend will continue.

We’ve seen a number of derivatives emerge with commodities, and while these products will likely continue, in many cases people can simply trade the commodity charts themselves, and we’re already moving in that direction. Certain products, like commodity ETFs, may not track a commodity market quite like trading the real thing, and as the real thing becomes more accessible, more people will likely opt for it.

Commodity trading has sure come a long way from where pig contracts were written on clay tablets, and is set to further evolve in the coming years as more and more people get turned on to it.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.