Why Commodities Are Traded

Commodities markets can be divided into two main sectors, the spot market for a commodity, and the futures or forward market for a commodity. The spot market is necessary to not only supply end users with commodities, and also allow producers to sell their products, it is also necessary to facilitate the future exchange of goods that futures markets price in.

When it comes to trading commodities, this always occurs in the futures market, as what is being traded so to speak is financial instruments, not physical assets. On the spot market, physical assets do change hands, for immediate delivery, but do not involve the exchange of securities that trading implies.

Trading in commodities involves buying or selling a contract to deliver or take delivery of a certain amount of a certain commodity, of a certain grade, at a certain price, in a certain currency, at a specific time in the future. There are significant benefits to both suppliers and users of commodities to have a market where they can lock in a future price of what they are looking to buy and sell.

Why Commodities Are TradedFor the parties who are directly involved in the future exchange of the physical commodities that are contracted for, the sole goal of these transactions is to look to minimize, or hedge against the risk of future price fluctuations.

This hedging allows for the smoother running of the businesses that produce and use commodities, by knowing what the price will be for these commodities a little in the future.

Once a futures contract for a commodity is created, with all of the terms specified, the contract gets traded on an exchange, or directly between traders on the forward market. The forward market for commodities is similar to the futures market other than futures contracts being traded on exchanges, with forward contracts not being traded on exchanges but over the counter.

Most commodities trading does not involve primary participants, although they do play an important role. If not for companies buying and selling commodities, there would obviously be no commodities market. The primary need for commodities drive the commodities market, even though most of the activity in the market is from those who have absolutely no intention of taking delivery of the goods.

Commodities Play a Central Role in the Economy

There are a lot of business inputs that are proprietary that cannot be exchanged in a public market. There is no commodity market for automobiles for instance, or parts for a specific automobile, because these are not generic goods and differ widely in many respects.

Commodities, on the other hand, are generic business inputs that are similar enough in quality to be exchangeable for one another. Because of this, the market for a particular thing, corn for instance, is both large enough and similar enough to be able to be widely traded enough that this trading can be made public.

The level of demand for something plays a big role in determining whether something will have a large enough market to warrant being traded in the futures market. There are many things that are generic enough, radishes for example, that do not have a futures market because not enough of the good changes hands.

A product like wheat on the other hand does have a huge market, enough to make it a major commodity. Commodities are very high use products that are used as business inputs in making other things, bread for instance with wheat.

Commodities are usually divided up into 4 major categories, which are metals, energy, livestock and meat, and agricultural products.

Energy based commodities that are traded include crude oil, gasoline, heating oil, ethanol, natural gas, propane, and purified terephthalic acid.

Agricultural commodities include corn, oats, rough rice, soybeans, soybean meal, soybean oil, rapeseed, wheat, milk, cocoa, coffee, cotton, sugar, and orange juice. Livestock and meat commodities are live cattle, lean hogs, pork bellies, and feeder cattle.

Metals are divided up into two sub categories, industrial metals and precious metals. The industrial metals that are traded as commodities are copper, lead, zinc, tin, aluminum, nickel, cobalt, molybdenum, and recycled steel. Precious metals traded are gold, silver, platinum, and palladium.

These all have industrial uses, even precious metals, even though the trading of these commodities is driven more by investment. Many components include precious metals, in addition to their being used for jewelry.

Being able to contract for goods in the near future does allow for more certainty in managing businesses which produce and use these commodities. This is like being able to see in the future and in fact futures contracts do allow businesses to do exactly that, and this allows them to plan better for the future.

The commodities that are traded exert a huge influence on the economy, and the amount of value and goods that changes hands on the futures commodity market represents a substantial portion of the economy.

The Added Liquidity of Speculation

There are some people who believe that allowing for speculation on commodities by traders should not be permitted, as this is seen by some as adding unnecessary risk and volatility to the market. Regardless of the extent of the truth of this, you can’t have securities traded in an open market and keep out certain participants.

Non-industrial participants do add a lot of liquidity to commodities trading, a huge amount, and most of the trading and the liquidity occurs from this participation. Commodity users to participate as well, and this is the reason why some complain, because they do buy and sell these contracts and wish for more stability of course.

However, for them to enter and exit markets easily, this does require that the futures contracts be widely available in the market, and traders provide more of them available, on both the buy and sell side, at any given time. What this does is add more price efficiency than you would see if the users and producers were the only ones trading these contracts.

Critics of the commodities market tend to underappreciate the value of market liquidity, and this is the same thinking that holds that short-term investors are harmful for other markets, which isn’t really the case either. Liquidity is king when it comes to market efficiency, and providing liquidity is the sole reason financial markets exist.

It may seem that someone may pay more for a contract due to speculation, but without it, they are more likely to get a worse price. The easiest way to understand this is that at any given time, if you’re looking to buy a futures contract on a commodity, and most of the participants are traders, the price available now is likely to be from a trader, and the producers are going to be further up the price chart.

So, you will pay more, and unless the best price is being offered by a producer, you will always pay more if not for the additional liquidity that traders provide. Some may claim that this additional market participation may add volatility to commodities pricing, and although this can produce some greater fluctuations during the life of the contract, its ultimate value will always be the value it has when redeemed.

Anything outside this would be a mistake, and if traders make mistakes and overvalue or undervalue a contract for a time, they are the ones losing, and this just adds to the sum of profits for those not making these mistakes, as commodities trading is a zero-sum game.

By getting involved in commodities trading, traders are, of course, looking to speculate on the price of the contracts moving their way in order to make a profit on them, but this serves to make the market more efficient, reducing spreads. If the spreads become larger than they should, traders will take advantage of this and narrow them, and simply by having more participants serves to narrow spreads.

Narrower spreads are always beneficial to the market and its participants, as the narrower the spread, the more efficient the market becomes. This means better prices on both sides, those looking to buy commodities futures contracts as well as those looking to sell.

The Real Role of Commodities Markets

Commodities markets do not exist fundamentally for any particular type of trader, whether that be the hedgers or the speculators. The hedgers often think that they are the primary participants, and while that may be true in a sense, as without their participation there would be no commodities market, nothing to bet on, but the idea of a market is to offer participation to anyone and everyone.

All financial markets involve participants making wagers of some sort, whether the wagers are used for insurance or risk management, or simply to seek to gain capital appreciation. The critics who believe that allowing for speculation turns commodities markets into casinos fail to realize that all financial markets are fundamentally casinos.

Even going into business involves making wagers, it’s all wagering, but out of this wagering comes the potential for profit and this is what drives everything. Commodities pricing in the future of course involves wagers, and everyone who buys or sells a contract is wagering, even the producers.

If the price ends up in their favor they profit, and if not, they lose, which sure looks like a wager. It is actually, pure and simple. In order for these wagers to be placed efficiently, you’re going to have to open up the market to everyone, and take on more bettors, and this is what all financial markets serve to do, including commodities markets.

Even though some financial markets may be set up simply to allow betting on certain things, even the most exotic derivatives do have some business purpose apart from allowing people to wager on something. It actually wouldn’t matter if this weren’t the case, as these markets would still be enough in demand to allow them to persist and thrive.

The commodities market is certainly well grounded in real life so to speak, perhaps more than anything else, as they allow for some very substantial amounts of business inputs to change hands in a way that allows for more efficient pricing and risk management than would otherwise be possible.

Commodities markets are by far the oldest financial market out there, and well-developed commodities markets go back hundreds of years. Candlestick trading was invented by Japanese rice traders all the way back in the 17th century, and many of their techniques are still used today.

Much of commodities trading takes place the old-fashioned way, using open outcry on exchange floors, and while this is not a particularly efficient way to trade anything, as it doesn’t take full advantage of the available technologies, these exchanges still use technology to a fair degree in spite of following old fashioned methods to some degree.

For those who are looking for more opportunities to trade, and can handle the additional risk that commodities trading involves, trading commodities can be well worth considering.

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.

Contact Ken: ken@marketreview.com

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