What exactly is commodity trading? The question that might many newcomers ask when they visit this site. Some of them have at least a rough idea that gold, silver, corn, or oil belong to the traded commodities. Fewer people know that recently you can also trade e.g. electricity or weather on the commodity exchange. So we came closer to the concept that more accurately captures the essence of the contracts being traded - Futures Trading.
Note: Futures are a broader term than Commodities are. This is because the commodity contracts are traded through Futures - future obligations to deliver or take delivery of something. The term "commodities" as such emphasizes physical side - the existing commodity (coffee, cotton, oil, etc.). Futures, however, highlight mainly the time characteristic - the delivery of assets or financial compensation in the Future - e.g. interest rate swap.
|Agricultural products||wheat, corn, rice, soybeans, coffee etc.|
|Animal products, meats||lean hogs, live cattle, milk, butter, etc.|
|Energies||oil, gas, ethanol, etc.|
|Metal, wood, plast||gold, silver, lumber, etc.|
|Financials||interest rates, FOREX currency pairs, etc.|
|Indices||S&P, Dow Jones, etc.|
|Specific products||greenhouse gas emissions, weather etc.|
Who takes part in the Futures trading?
Commodity traders (or Futures traders) can be divided into two basic groups:
- Trader (speculators, investors)
- Hedgers (those who need to hedge their positions against a sudden drop or increase in prices)
Traders make their money by buying and selling assets:
- If they buy eg. contract of oil and the price rises, they make money on rising prices.
- If the price of oil would fall, then the traders would lose their money until they get rid of the contract by a sale.
- If they sell a contract of oil (the commodity can be borrowed from the clearing house and sold then) and the price declines, then they make money because of the falling price
- If the price of oil would rise, traders lose their money until they buy a contract to settle their positions with the clearing house.
All transactions are made through the Clearing House. If you buy, you buy from it. If you sell, you sell to it again. The trading lasts to the LTD - Last trading day, when just the quantity of goods that is actually necessary for the physical delivery remains on the market. The main importance of the Clearing House is in setting more effective prices as there is more trades agreed which means higher competition. The price wouldn't be so effective if there was only a limited number of buys and sales.
Hedgers operate on another principle.
Their primary role is hedging of their positions. Let's suppose that the producer wants to hedge corn price at $ 5 per Bushel (Bushel = approximately 35 liters, the size is different for most commodities).
Hedger intends to deliver the crop of Corn to the customer e.g. in 6 months, in the quantity of 50,000 bushels. Its current price is, let's say, $ 5 per Bushel. However, the hedger needs to be sure that the price will not sink any lower. The hedger therefore sells the requisite number of contracts (in this case it would be 10 contracts, whereas 1 contract equals to 5,000 bushels) to cover his anticipated production of 50,000 bushels of corn.
By selling the contracts the Hedger is (temporarily) oblidged to deliver a standardized quantity of goods in a standardized time and quality, to a specific point of delivery for a future price.
There may be 2 options for hedgers:
1. If the price of Corn after the next 6 months falls to eg. $ 4/Bushel, hedger closes his positions (buys 10 contracts of Corn at a price of $ 4/Bushel). Result:
10 contracts * 5000 bushels/contract * $ 5/Bushel = 250,000 USD
At the closing of his positions he buys the contracts at a price:
10 contracts * 5,000 bushels/contract * $ 4/Bushel = 200,000 USD
Hedger's profit is 50,000 dollars and he has no further obligations resulting from the contracts. His harvest of Corn crop can be sold at the local market, where price will likely oscillate around the current market price of 4 USD. Hedger earns exactly the same money, as he planned to: 200,000 USD for the crop + 50,000 dollars from the hedging of price. I.e. he fulfilled his goal and is in a profit of 250,000 USD thanks to his crop + hedging.
2. The second option is that the price will rise from 5 to 6 USD per Bushel of Corn. Then the reverse analogy is true as in the previous case. When hedger buys back the contracts of Corn, he pays for them 50,000 USD more. On the other hand, he can sell the harvested crop at a price of $ 6 per Bushel. So he can earn 300,000 USD for the crop less 50,000 USD from the commodities trading. His trading Loss and Excess profit from the crop makes again the desired profit of 250,000 USD.
The essence of hedging is explained in the example above. Of course, the hedgers do not have to close all their positions at the time of Last Trading Day. In such case they take the obligation to take physical delivery or deliver the contracted commodity to the market. The vast majority of contracts ends by offsetting positions and not by physical delivery of commodities.
Conclusion: The most traded contracts were the agricultural products (corn, wheat), in the past. In recent years, however, the contracts of financial instruments, like currencies and interest rates, became the most traded.