Commodities: The Basics

Commodities are products which meet an agreed specification, such that the only negotiating point is the price to be paid. The products are standardised products, goods or services that are not traded based on quality and features, only on price. Historically, commodities were items of value, of uniform quality that were produced in large quantities by many different producers. The items from each different producer were considered equivalent. Commodities are defined by an underlying contract and standard specification, with an assumed uniformity of quality.

History

The first commodities market was held in Chicago, in the early 19th Century. Farmers would bring their wheat to the market and exchange it for cash. Futures contracts developed from there. A farmer would contract with a dealer to sell a set amount of produce to him at a set date for a set price. It was good for both parties since the farmer knew how much he was going to get paid and the dealer knew exactly how much he was going to pay for these commodities.

This practice of commodities trading evolved over the years that ensued. The farmer would decide not to sell and cede the contract to another farmer to fulfil, or the dealer might decide that he did not want the produce anymore and then on-sell the contract to another dealer. Naturally supply and demand entered the equation. If the harvests were poor, the produce would fetch a much higher price and if the crops were abundant, a lower price prevailed.

Inevitably, speculators got in the game. They started trading the futures contracts in the hope of buying the commodities at a low price and selling these for a handsome profit.

What defines a successfully tradable commodity?

To be traded successfully, commodities must:

·Be standardized. If the commodity is industrial or agricultural, it must be unprocessed.

·Have an adequate shelf-life, if they are agricultural.

·There should be sufficient fluctuation in supply and hence price. The reason for this is that without the risk factor, there is little margin for profits.

Examples of commodities are: electricity, wheat, chemicals, metals, pork bellies, RAM chips.

Difference between commodities and stocks

The main difference between stocks and futures contracts from a trading perspective is that, unlike stocks, which you could keep for a very long time, commodities are held for a very short time only. Futures contracts are used to hedge commodity price-fluctuation risks or to take advantage of price movements, instead of trading the actual physical commodities.

How are commodities traded?

Commodity Futures and options trading take place at exchanges such as the Chicago Board of Trade, Euronext.liffe, London Metal Exchange and the New York Mercantile Exchange, and other online trading systems. At the exchanges, areas are provided, each designated for a different futures contract. Those trading on the floor must be members of the exchange and registered with the Commodity Futures Trading Commission, or work through brokerage firms who are members.

Commodity futures option trading is both complex and risky, so it does not suit everyone. If you are considering commodity future option trading, you should consider how much you are prepared to risk losing. Choose a trading method that you are comfortable with and that is best suited to achieving your objectives. The bottom line in commodity future option trading is that, if you exercise good judgment and manage your risks effectively, commodities trading may richly reward your efforts!